RETAIL RATE FORECASTS

François Dupuis, Vice-President and Chief Economist • Mathieu D’Anjou, Senior Economist • Hendrix Vachon, Senior Economist

Desjardins, Economic Studies: 514-281-2336 or 1 866-866-7000, ext. 5552336 • desjardins.economics@desjardins.com • desjardins.com/economics

NOTE TO READERS: The letters k, M and B are used in texts and tables to refer to thousands, millions and billions respectively.IMPORTANT: This document is based on public information and may under no circumstances be used or construed as a commitment by Desjardins Group. While the information provided has been determined on the basis of data obtained from sources that are deemed to be reliable, Desjardins Group in no way warrants that the information is accurate or complete. The document is provided solely for information purposes and does not constitute an offer or solicitation for purchase or sale. Desjardins Group takes no responsibility for the consequences of any decision whatsoever made on the basis of the data contained herein and does not hereby undertake to provide any advice, notably in the area of investment services. The data on prices or margins are provided for information purposes and may be modified at any time, based on such factors as market conditions. The past performances and projections expressed herein are no guarantee of future performance. The opinions and forecasts contained herein are, unless otherwise indicated, those of the document’s authors and do not represent the opinions of any other person or the official position of Desjardins Group. Copyright © 2017, Desjardins Group. All rights reserved.

Rates Will Continue to Go Up in 2018HIGHLIGHTS

f The economic context remains very favourable.

f Interest rates will continue to rise in the coming quarters.

f The Canadian dollar is still being held back by the Bank of Canada’s cautious stance.

f More modest returns for asset classes in 2018.

• The global economic outlook is favourable for 2018. Advanced economies, with the United States and the euro zone leading the pack, have continued to post impressive economic performance in recent months. The labour market also continues to do very well in many countries. While confidence indexes are still very high, everything suggests that global economic growth will remain sustained next year (graph 1).

• The Federal Reserve (Fed) will continue its monetary tightening. Given the strong performance of the U.S. economy and job market, the Fed now seems poised to raise its key interest rates by 0.25% at its December 13 meeting. After three increases in 2017, a similar monetary tightening is expected by the Fed in 2018. Fears of economic

overheating could even warrant slightly quicker monetary tightening. The persistent weakness in inflation and wages (graph 2) should, however, convince Fed leaders to keep the pace of interest rate hikes gradual.

• Canadian domestic demand is still very strong. After a spectacular surge in the first half of the year, Canadian GDP posted more subdued growth of 1.7% in the third quarter of 2017. This slowdown was in line with expectations, but Canadian domestic demand, particularly household consumption, remained very robust (graph 3 on page 2). The latest labour market and real estate data also greatly exceeded expectations.

ECONOMIC STUDIES | DECEMBER 12, 2017

GRAPH 2 Job creation remains very strong in the United States, but wages are still a bit weak

Sources: Bureau of Labor Statistics and Desjardins, Economic Studies

In thousands

1.51.71.92.12.32.52.72.9

0

50

100

150

200

250

300

350

2014 2015 2016 2017

Job creation according to the establishment survey (left)Average hourly wage (right)

Annual variation in %

GRAPH 1 Global economic growth is expected to continue accelerating next year

Sources: World Bank, Consensus Forecasts and Desjardins, Economic Studies

Global real GDP growth – According to purchasing power parity

Annual variation in %

2.5

3.0

3.5

4.0

4.5

2011 2012 2013 2014 2015 2016 2017 2018 2019

Desjardins forecasts

#1 BEST OVERALLFORECASTER - CANADA

ECONOMIC STUDIES

2DECEMBER 2017 | RETAIL RATE FORECASTS

• The Bank of Canada (BoC) is expected to raise its key interest rates soon. It comes as no surprise that the BoC kept its monetary policy unchanged at its December 6 meeting. A rate hike announcement is, however, expected in the coming months, as, by all indications, the Canadian economy’s excess capacity continues to shrink and since the two rate increases this past summer did not appear to have a major impact on Canadian consumer confidence or spending. High household debt also calls for a gradual rise in interest rates.

• The uptrend in bond yields should become clearer soon. After surging this summer, Canadian bond yields came down somewhat when the BoC took a more cautious stance in early fall. U.S. yields, however, have increased significantly in recent months, reflecting a favourable economic outlook and the imminent increase in federal funds. Canadian bond yields should resume their upward trend as soon as the BoC signals that it is ready to continue its monetary tightening.

• A gradual rise in retail rates is still expected. With the BoC taking a break this fall, borrowers were given some respite after the fairly abrupt rate hikes this summer. However, the most recent economic statistics confirm that Canadians need to be prepared for further retail rate increases in 2018 and 2019, even though the BoC’s exact timing will likely remain difficult to predict.

DISCOUNT RATE

PRIME RATE

1 year 3 years 5 years 1 year 3 years 5 years

Realized (end of month)June 2017 0.75 2.70 3.14 3.39 4.74 0.85 1.15 1.50July 2017 1.00 2.95 3.14 3.39 4.74 0.85 1.15 1.50August 2017 1.00 2.95 3.24 3.39 4.84 0.90 1.15 1.55Sept. 2017 1.25 3.20 3.24 3.59 4.84 0.90 1.15 1.55Oct. 2017 1.25 3.20 3.39 3.74 4.99 0.90 1.15 1.55Nov. 2017 1.25 3.20 3.39 3.74 4.99 0.90 1.15 1.55Dec. 11, 2017 1.25 3.20 3.39 3.74 4.99 0.90 1.15 1.55

ForecastsEnd of quarter2017: Q4 1.25 3.20 3.29–3.59 3.64–3.84 4.89–5.19 0.80–1.10 1.05–1.35 1.45–1.752018: Q1 1.25–1.75 3.20–3.70 3.35–3.85 3.60–4.10 4.80–5.30 0.85–1.35 1.05–1.55 1.45–1.952018: Q2 1.25–1.75 3.20–3.70 3.45–3.95 3.60–4.10 4.90–5.40 0.95–1.45 1.25–1.75 1.55–2.052018: Q3 1.50–2.00 3.45–3.95 3.55–4.05 3.80–4.30 5.10–5.60 1.25–1.75 1.50–2.00 1.70–2.25End of year2018 1.50–2.50 3.45–4.45 3.75–4.55 3.85–4.65 5.15–5.95 1.30–2.10 1.60–2.40 1.85–2.652019 2.00–3.00 3.95–4.95 4.15–4.95 4.30–5.10 5.60–6.40 1.85–2.65 2.00–2.80 2.25–3.052020 2.00–3.00 3.95–4.95 3.85–4.65 4.00–4.80 5.20–6.00 1.60–2.40 1.75–2.55 1.85–2.65

1 Non-redeemable (annual); NOTE: Forecasts are expressed as ranges.Source: Desjardins, Economic Studies

TABLE 1Forecasts: Retail rate

IN %

MORTGAGE RATE TERM SAVINGS1

2.2

3.7 4.3

1.7

-4

-2

0

2

4

6

8

Q42016

Q12017

Q2 Q3

Net exports

Change in inventories and residual error

Gross fixed capital formation

Consumer spending

Total

GRAPH 3 International trade curbed real Canadian GDP growth in Q3 2017

Sources: Statistics Canada and Desjardins, Economic Studies

Contributions to annualized quarterly change in real GDP

In %

3DECEMBER 2017 | RETAIL RATE FORECASTS

ECONOMIC STUDIES

• The Canadian dollar reacted positively to the latest Canadian economic data, which often beat expectations. However, the Bank of Canada (BoC) maintained a stance deemed to be cautious, and the Canadian dollar was unable to hold on to its gains. It is currently hovering at close to US$0.78 (C$1.28/US$). If not for higher oil prices to support it, the value of the Canadian dollar would probably be closer to US$0.75, as suggested by the adverse shift in the interest rate spreads between Canada and the United States (graph 4).

• The U.S. dollar momentum slowed in November. The first week of December was better, but overall the U.S. currency is having trouble profiting from rising interest rates in the United States. Other factors are clouding the issue, such as changes in investors’ appetite for risk. The U.S. dollar appears to be penalized when investors have a stronger taste for risk. The poor performance of the U.S. dollar also seems to be linked to persistently low inflation and the fact that the markets are not expecting a high potential for monetary tightening in the coming years (graph 5).

• Forecasts: The Canadian dollar should remain close to US$0.78 in the short term, but is expected to appreciate slightly in the longer term. There is a greater likelihood of the BoC raising interest rates again in the first quarter of next year, suggesting that the unfavourable trend in interest rate spreads with the United States is drawing to a close. Lower uncertainty about the North American Free Trade Agreement (NAFTA) could help the loonie, but the opposite is also possible. Economic surprises could inject volatility into the currency, in parallel with monetary tightening expectations.

Exchange RateThe Canadian Dollar Is Still Being Held Back by the BoC’s Cautious Stance

Sources: Datastream and Desjardins, Economic Studies

US$/C$

-80

-60

-40

-20

0

20

40

0.65

0.70

0.75

0.80

0.85

2015 2016 2017 2018

Canadian exchange rate (left)Spreads between 2-year yields with the United States (right)

Spreads in basis points

GRAPH 4 The Canadian dollar has stabilized around US$0.78

GRAPH 5 The greenback rebound has lost steam

Sources: Bloomberg and Desjardins, Economic Studies

DXY effective exchange rate

Index

90

92

94

96

98

100

102

104

2015 2016 2017 2018

Q3 Q4f Q1f Q2f Q3f Q4f Q1f Q2f Q3f Q4f

US$/CAN$ 0.8020 0.7800 0.7800 0.7800 0.7900 0.7950 0.8000 0.8000 0.8100 0.8200CAN$/US$ 1.2470 1.2821 1.2821 1.2821 1.2658 1.2579 1.2500 1.2500 1.2346 1.2195CAN$/€ 1.4741 1.5128 1.5000 1.5128 1.5063 1.5094 1.5250 1.5500 1.5432 1.5366US$/€ 1.1822 1.1800 1.1700 1.1800 1.1900 1.2000 1.2200 1.2400 1.2500 1.2600US$/£ 1.3417 1.3300 1.3200 1.3100 1.3000 1.3000 1.3100 1.3200 1.3200 1.3300

f: forecastsSources: Datastream and Desjardins, Economic Studies

TABLE 2Forecasts: Currency

END OF PERIOD

2017 2018 2019

Determinants Short-term Long-term

Oil prices → ↗Metals prices → ↗Interest rate spreads → ↗

ECONOMIC STUDIES

4DECEMBER 2017 | RETAIL RATE FORECASTS

• Stock markets are continuing to perform well. Encouraging developments that are now suggesting that a tax reform will be signed in Washington by the end of the year have driven a number of stock indexes to new historic highs over the past few weeks. However, some uncertainty has emerged in recent days, as lower corporate tax rates might not be taking effect until 2019 and reform details might be less favourable than expected for some sectors. Either way, there is no doubt that 2017 will have been another milestone year for investors, as stock markets, particularly foreign ones, skyrocketed without leaving the bond market too worse for wear (graph 6).

• The U.S. stock market is not cheap, but it could stay that way. After another year of spectacular growth, it is clear that the U.S. stock market may seem overvalued to some investors. In particular, there has been a leap in the ratio between the total capitalization of the U.S. stock market and GDP in recent years, getting very close to levels seen during the tech bubble (graph 7). However, this ratio does not take into account strong corporate earnings growth, which jumped roughly 20% in the case of the S&P 500 in 2017, and extremely low interest rates, which justify higher price/earnings ratios than in the past (graph 8). As the uptrend in interest rates should become clearer, we are expecting decent performance of about 7% for the S&P 500 next year. Profit taking could, however, lead to temporary setbacks.

• Higher commodity prices are encouraging for the Canadian stock market. After a disappointing first half to 2017, industrial commodity prices have recovered significantly since the summer. The renewed optimism was initially mostly felt in industrial metals, but oil prices also posted strong gains recently, hitting nearly US$60 a barrel. The recent rise in oil prices is buoyed by many factors, including a spike in Middle East tensions, but there is no doubt that signs of acceleration in the global economy is great news for industrial commodities. This more positive sentiment concerning resources led to decent performance on the Canadian stock market in 2017 despite a difficult start to the year, and it could help it post slightly stronger performance than foreign indexes in 2018.

• The bond market could have a more difficult year ahead in 2018. One of the pleasant surprises of 2017 is that the Canadian bond market will have posted returns of roughly 3% despite the Canadian economy’s excellent performance and the Bank of Canada’s two rate hikes. This is mainly due to the fact that, unlike short-term rates, long-term yields have remained very low, which has resulted in a significant

Asset Classes ReturnMore Modest Returns Are Expected in 2018

GRAPH 6 Another great year for asset classes, particularly foreign

Sources: Datastream and Desjardins, Economic Studies

January 2017 = 100

90

100

110

120

130

140

JAN. MAR. MAY. JUL. SEP. NOV.

U.S. stock marketOverseas advanced stock marketsEmerging stock marketsCanadian stock marketCanadian bonds

2017

GRAPH 8 Stock markets remain attractive compared to the bond market

Sources: S&P Dow Jones Indices, Datastream and Desjardins, Economic Studies

Index

0

5

10

15

20

02468

10121416

1960 1970 1980 1990 2000 2010

Inverse of the S&P 500 cyclically adjusted price-to-earnings ratio (left)U.S. 10-year yield (right)

In %

GRAPH 7 Relative to the economy, the stock market seems very expensive

Sources: Datastream and Desjardins, Economic Studies

Ratio between Wilshire 5000 and U.S. nominal GDP

In %

30

50

70

90

110

130

150

1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

5DECEMBER 2017 | RETAIL RATE FORECASTS

ECONOMIC STUDIES

• Despite a fairly favourable context, returns are expected to be more constrained in 2018. Sustained strong economic growth is good news for stock markets, as it suggests further growth in corporate earnings. Aside from having an adverse effect on the bond market, a clearer rise in interest rates may somewhat limit returns of foreign stock exchanges after the remarkable gains in 2017. The most harmful scenarios for investors would be a dramatic deterioration in the economic outlook or, conversely, a pickup in inflation that would force central banks to sharply accelerate monetary tightening. For the time being, however, there is no sign that the economic situation will be going down that road in 2018.

flattening of the yield curve (graph 9). The persistence of low inflation in a number of countries and doubts as to central banks’ willingness to normalize monetary policy helped curb upward pressure on long-term bond yields. As the temporary factors that drove inflation down should dissipate and the steep drop in excess production capacity should put upward pressure on wages, we are expecting a more widespread rise in North American bond yields in the coming quarters. This should translate into a slightly negative return for the Canadian bond market in 2018.

CASH BONDSCANADIAN

STOCKSU.S. STOCKS

INTERNATIONAL STOCKS

EXCHANGE RATE

3-monthT-Bill Bond index1 S&P/TSX

index2

S&P 500 index (US$)2

MSCI EAFE index (US$)2

C$/US$(variation in %)3

2006 4.0 4.1 17.3 15.8 26.9 0.22007 4.1 3.7 9.8 5.5 11.6 -14.42008 2.4 6.4 -33.0 -37.0 -43.1 22.12009 0.3 5.4 35.1 26.5 32.5 -13.72010 0.6 6.7 17.6 15.1 8.2 -5.22011 0.9 9.7 -8.7 2.1 -11.7 2.32012 1.0 3.6 7.2 16.0 17.9 -2.72013 1.0 -1.2 13.0 32.4 23.3 7.12014 0.9 8.8 10.6 13.7 -4.5 9.42015 0.5 3.5 -8.3 1.4 -0.4 19.12016 0.5 1.7 21.1 12.0 1.5 -2.9

2017f target: 0.70 target: 3.0 target: 8.0 target: 20.0 target: 22.5 target: -4.6 (US$0.78)range 0.65 to 0.75 2.5 to 3.8 5.0 to 11.0 17.0 to 23.0 19.0 to 25.0 -6.9 to -2.0

2018f target: 1.50 target: -1.5 target: 9.0 target: 7.0 target: 7.0 target: -1.9 (US$0.795)range 1.15 to 1.75 -3.5 to 2.0 4.0 to 14.0 2.0 to 12.0 -1.0 to 14.0 -6.0 to 2.6

TABLE 3Asset classes percentage return

END OF YEAR IN %(EXCEPT IF INDICATED)

1 FTSE TMX Canada Bond Universe; 2 Dividends included; 3 Negative = appreciation, positive = depreciation; f: forecastsSources: Datastream and Desjardins, Economic Studies

GRAPH 9 Narrowing spreads between long- and short-term rates favoured the bond market in 2017

Sources: Datastream and Desjardins, Economic Studies

In %

0.0

0.5

1.0

1.5

2.0

2.5

3.0

2015 2016 2017 2018

2-year yield 10-year yield