More like the rest than like the US

More like the rest than like the US? Canada’s Economic & Financial Outlook David D. Wolf Head of Canadian Economics & Chief Strategist Merrill Lynch Canada Inc. May 2007 d_wolf@ml. com 416. 369. 8764 Merrill Lynch does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Refer to important disclosures on page 13.

May 2007 Key points Theme - Canada leaning more towards stronger world than weaker US Economy - Growth, inflation moving above US after three-year undershoot - Real GDP 2. 3% ‘ 07, 2. 6% ‘ 08, core inflation 2. 2% ’ 07, 2. 0% ’ 08 Rates & FX - Canada-US rate convergence required given economic ‘cross’ - CAD has borne adjustment so far, seen 1. 09 – 1. 14 v USD - Convergence eventually through Bo. C lagging Fed cuts, producing broadly steady yields & steeper curve Equities 2 - TSX following global multiple expansion as earnings soften

May 2007 US growth, inflation shifting down The slowdown Not just housing anymore Source: Haver Analytics, Merrill Lynch Core inflation set to ebb Source: Haver Analytics, Merrill Lynch Notes: Source: Haver Analytics, Merrill Lynch 3

May 2007 But rest of the world picking up Divergence is not new… … but it is intensifying Source: Haver Analytics, IMF, Merrill Lynch Global inflation risks skewed Source: Haver Analytics, Merrill Lynch Notes: Source: Haver Analytics, Merrill Lynch 4

May 2007 Ex ante, hard to know which way Canada would lean Top three is really top one But world matters most for export values… Source: Haver Analytics, Merrill Lynch … which feed domestic demand Source: Haver Analytics, Merrill Lynch Notes: Source: Haver Analytics, Merrill Lynch 5

May 2007 Canada is overtaking US in growth Opening up daylight in real GDP Leading indicator divergence I Source: Haver Analytics, Merrill Lynch Leading indicator divergence II Source: Haver Analytics, Merrill Lynch Notes: Source: Haver Analytics, Merrill Lynch 6

May 2007 Canada consumer fundamentals better Recent job growth impressive Canadian incomes have accelerated Source: Haver Analytics, Merrill Lynch Leverage growing less quickly Source: Haver Analytics, Merrill Lynch Notes: Source: Haver Analytics, Merrill Lynch 7

May 2007 Actual consumption growth has slipped, but should rebound some Canada spending trend has been stronger Source: Haver Analytics, Merrill Lynch Soft patch in recent months… Source: Haver Analytics, Merrill Lynch … seems to have ended with spring Source: Haver Analytics, Merrill Lynch 8

May 2007 Housing offers most striking divergence US busting, Canada leveling off Higher inventories suggest softer pricing… Source: Haver Analytics, Merrill Lynch … but from less frothy levels Source: Haver Analytics, Merrill Lynch Notes: Source: Haver Analytics, Merrill Lynch 9

May 2007 Fiscal policies divergent too Coming together H 2 slowdown in public spending… Source: Haver Analytics, Merrill Lynch … also looks temporary Source: Haver Analytics, Merrill Lyn Notes: Source: Finance Canada, Merrill Lynch 10

May 2007 Business investment trends look more like the US Caution! Intentions also soft, energy off the boil Source: Haver Analytics, Merrill Lynch Softer profits, Cap. U the cause? Source: Haver Analytics, Merrill Lync Notes: Source: Haver Analytics, Merrill Lynch 11

May 2007 Inventories a key question mark Much of the needed adjustment done in Q 4 I/S ratio suggests downside… Source: Haver Analytics, Merrill Lynch … but Bo. C forecast implies a bounce Source: Haver Analytics, Merrill Lyn Notes: Source: Haver Analytics, Merrill Lynch 12

May 2007 Real exports can’t escape US drag Real exports depend on US demand Canada does build US houses Source: Haver Analytics, Merrill Lynch Manufacturing overhang still to be worked off Source: Bank of Canada Notes: Source: Haver Analytics, Merrill Lynch 13

May 2007 But some resilience evident near-term Manufacturing survey bounces in Q 2… … eliminating underperformance vs US Source: Haver Analytics, Merrill Lynch Auto sector apparently through correction Source: Haver Analytics, Merrill Lync Notes: Source: Haver Analytics, Merrill Lynch 14

May 2007 Near-term bounce partly reflects ebbing regional divergences Full convergence in manufacturing Some convergence even in job growth Source: Haver Analytics, Merrill Lynch Alberta house prices off the boil Source: Haver Analytics, Merrill Lyn Notes: Source: Haver Analytics, Merrill Lynch 15

May 2007 Canada-US ‘growth cross’ comes amid already-tighter Canadian economy… Canadian growth seen above US in 2007… … from already higher position Source: Haver Analytics, Merrill Lynch Labour markets levels also contrast Source: Haver Analytics, Merrill Lync Notes: Source: Haver Analytics, Merrill Lynch 16

May 2007 … promoting inflation convergence Headline CPI differential has narrowed Core CPI differential almost gone Source: Haver Analytics, Merrill Lynch Producer prices have also converged Source: Haver Analytics, Merrill Lynch Notes: Source: Haver Analytics, Merrill Lynch 17

May 2007 Capacity pressures on Canadian inflation questionable Productivity softer, but wages too Labour market flexibility the key? Source: Haver Analytics, Merrill Lynch Capital deepening should help too Source: Haver Analytics, Merrill Lynch Notes: Source: Haver Analytics, Merrill Lynch 18

May 2007 Bottom-up approach sees divergent influences House pressure coming off… … perhaps replaced by food? Source: Haver Analytics, Merrill Lynch Core goods contrast with core services Notes: Source: Haver Analytics, Merrill Lynch 19

May 2007 Money & credit indicators a marginal worry to the upside Narrow money suggests stronger growth Broad money has accelerated Source: Haver Analytics, Merrill Lynch Credit growth slower but still elevated Notes: Source: Haver Analytics, Merrill Lynch 20

May 2007 Canada inflation outlook mixed vs downside in US CPIX likely to come down to target… … but not as fast as in the US Source: Haver Analytics, Merrill Lynch Reversing the recent differential Source: Haver Analytics, Merrill Lynch Notes: Source: Haver Analytics, Merrill Lynch 21

May 2007 Canada growth, inflation rising above US Real, nominal interest rates remain below US Something has to give 22

May 2007 So far, it’s been the currency that’s borne the brunt of adjustment… An abrupt reversal in trend Mostly Type I? Source: Haver Analytics, Merrill Lynch Or Type II? Source: Haver Analytics, Merrill Lynch Notes: Source: Haver Analytics, Merrill Lynch 23

May 2007 … more than enough, if the US does what we expect Stronger CAD path… … tilts down economic profile… Source: Haver Analytics, Merrill Lynch … even with lower rates, assuming Fed Notes: cutting Source: Haver Analytics, Merrill Lynch 24

May 2007 Leaving higher CA-US base case on mixed rates, steeper curve Positive spreads seen by 2008 Canadian yields seen higher on net Source: Haver Analytics, Merrill Lynch A steeper curve Source: Haver Analytics, Merrill Lynch Notes: Source: Haver Analytics, Merrill Lynch 25

May 2007 Most confident aspect of rate forecast is Canada-US convergence Spreads have followed inflation gap… Source: Haver Analytics, Merrill Lynch … and jobs gap Source: Haver Analytics, Merrill Lynch If Fed on hold, expect convergence up Notes: Source: Haver Analytics, Merrill Lynch 26

May 2007 Canadian equities have attended the global party TSX has built on 2002 -06 doubling… Concentration in high beta sectors has helped Source: Haver Analytics, Merrill Lynch As has M&A/private equity boom Source: Haver Analytics, Merrill Lynch Notes: Source: Haver Analytics, Merrill Lynch 27

May 2007 Multiple expansion has taken over as earnings flatten out Trailing earnings flat, forward earnings falling Macro factors suggest further softness Source: Haver Analytics, Merrill Lynch But higher valuations have more than made it up Source: Haver Analytics, Merrill Lynch Notes: Source: Haver Analytics, Merrill Lynch 28

May 2007 Has abundant global liquidity made the ‘Fed model’ apply? Earnings yields above bond yields… … leave an apparently juicy spread Source: Haver Analytics, Merrill Lynch Hasn’t worked in the past, but… Source: Haver Analytics, Merrill Lynch Notes: Source: Haver Analytics, Merrill Lynch 29

May 2007 Risk of adverse shift in fund flows, too Historic underweight in foreign assets ebbing… … in both bonds and stocks Source: Haver Analytics, Merrill Lynch Foreign portfolio inflows have offset, for now Source: Haver Analytics, Merrill Lynch Notes: Source: Haver Analytics, Merrill Lynch 30

May 2007 Canada among markets vulnerable to reassessment of risk Volatility is low… Source: Haver Analytics, Merrill Lynch … and risk appetite is high Source: Haver Analytics, Merrill Lynch Lowered risk premiums – the apparent consequence of a long period of economic stability –coupled with greater productivity growth have propelled asset prices higher… this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk 31

May 2007 Key economic & financial forecasts 32

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