Fall 2008

A strong Canadian dollar (CAD) and weak U.S. demand are projected to drag down growth in Canada to less than 1% over the next year. In turn, the same factors should help U.S. growth by reducing the negative effect from its net trade balance. Further ahead, we expect that reduced commodity prices and near-potential U.S. growth will result in a more sustainable trade relationship for the two nations. From the policy point of view, the Bank of Canada (BoC) maintains accommodative rates with only a small risk that they will fan inflation pressure, while the Fed has kept rates consistent with low expected inflation and stable growth. However, in light of recent developments, we now expect additional easing before the year’s end. Furthermore, the Fed and the BoC continue to beef up liquidity via nontraditional lending measures. (continued on page 3)

10/10/07

12/19/07

02/27/08

05/07/07

07/16/08

09/24/08

With spending generally tracking disposable income... Disposable income

Spending

14 12 10 8 6 4 2 0 1/1/85

1/1/90

1/1/95

1/1/00

1/1/05

1/1/08

Source: Bureau of Economic Analysis (BEA), Economic Research

…a weakening job market will put a dent in consumer spending going forward Unemployment-R

Spending-L

9 8 10 7 6 8 5 6 4 Jul Jan Jul Jan Jul Jan Jul Jan Jul Jul 3 4 Jan 1998 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2 2 1 0 0 1/1/85 1/1/90 1/1/95 1/1/00 1/1/05 1/1/08 12

Unemployment Rate

Oil prices have retreated from their July peak, providing some relief for stressed American consumers. In contrast, Canada is a net energy exporter, making the rise in energy prices a boon for a large sector in Canada’s economy.

400 350 300 250 200 150 100 50 0 08/01/07

Source: Federal Reserve Bank

Income & spending (yoy)

Credit markets in the U.S. remain in turmoil and predictions of major bank failures persist. In contrast, the financial and housing sectors in Canada remain largely immune to the housing troubles in the U.S. Surprisingly, the U.S. economy may still be growing while its Canadian counterpart is already treading water. Nonetheless, the weak U.S. employment market and the debacle on Wall Street are worrisome, and pose a high risk of a sharper slowdown than we are projecting as we go to print on October 1st. In Canada, the unemployment rate remains at historic lows and the recovery in August payroll suggests that the domestic economy is making headway. The risk here is also that growth will be much weaker than anticipated, dragged down by weakness south of the border.

Spending (yoy)

Darkness before the dawn

3m LIBOR - 3m (bps)

Despite huge injections of liquidity, the message from inter-banking lending is total lack of confidence

North American Economic Outlook

Source: BEA, Bureau of Labor Statistics, Economic Research

1

North American Economic Outlook Fall 2008

U.S. Forecast Summary % Change at annual rate

Year-over-Year % Change or Annual Average

History Forecast



2007.3 2007.4 2008.1 2008.2

2008.3 2008.4 2009.1 2009.2 2009.3 2009.4

2006 2007 2008 2009 2010

1.0 -1.5 -0.5 -2.3 -1.6 -1.2 -11.6 -12.4 2.8 1.5 -25.2 -23.0 8.9 6.6 4.1 3.3 -6.9 -0.5 10.0 -15.6 6.0 6.4 967 894

2.8 2.0 1.6 3.0 2.8 0.8 7.5 4.9 3.1 -7.1 -17.9 -19.7 1.7 2.1 2.5 42.3 -2.5 -27.3 9.1 8.4 9.2 6.0 2.2 -1.2 3.5 2.8 1.5 15.2 -1.6 -4.6 4.6 4.6 5.7 1812 1341 984

Real U.S. GDP and Components Gross domestic product 4.8 -0.2 0.9 Personal consumption expenditures 2.0 1.0 0.9 Business fixed investment 8.7 3.4 2.4 Residential investment -20.6 -27.0 -25.1 Government purchases 3.8 0.8 1.9 Change in inventories 16.0 -8.1 -10.2 Exports 23.0 4.4 5.1 Imports 3.0 -2.3 -0.8 Real disposable income 3.1 0.6 -0.7 Corporate profits with IVA & CCAdj -1.0 -13.0 -4.3 Unemployment rate % 4.7 4.8 4.9 Private housing starts (thous. units) 1298 1151 1053 Prices GDP Price Index Consumer Price Index: CPI-U CPI-U excl. food & energy Foreign Exchange Rate (Broad trade-weighted value of US$) Refiners’ cost of imported oil ($/b)

70.4

U.S. Interest Rates (avg. %) Federal Funds Rate Ninety-day Treasury Bill Rate 3-month LIBOR 10-year Treasury Note Yield

5.1 4.5 4.31 3.39 5.47 5.11 4.73 4.26

1.5 2.8 2.8 5.0 2.5 2.5 -7.2 -13.1 82.4

2.6 4.3 2.5 -7.2

2.8 1.2 2.5 -13.3 3.9 -50.6 12.3 -7.3 11.9 -9.2 5.3 1023

1.5 0.9 1.3 -3.4 -1.0 -4.6 6.9 2.8 2.6 12.7 6.5 975

2.0 1.8 -0.1 3.0 1.1 -1.3 7.3 3.7 2.5 2.2 6.7 919

2.7 2.5 -0.8 1.2 2.0 8.9 7.3 4.8 2.2 11.3 6.5 964

3.0 2.8 -0.3 18.1 1.6 16.0 7.3 6.0 2.7 10.5 6.4 1079

2.7 2.9 2.3 -4.7

2.3 4.5 2.3 -5.4

1.3 2.9 0.6 2.1 -0.1 3.8 -4.0 19.0 1.2 1.4 4.7 25.2 7.6 6.5 3.0 5.0 1.2 3.1 2.8 4.6 6.5 6.2 984 1234

1.2 5.0 1.9 -6.1

3.3 6.3 2.2 13.8

2.6 2.2 2.8 1.3

2.5 2.6 2.4 0.5

1.9 1.9 2.0 3.2

2.1 2.4 2.5 1.4

2.1 2.3 2.4 1.5

3.2 3.2 2.5 -2.0

2.3 2.9 2.3 2.5

2.4 2.9 3.0 2.4

89.8 115.6

117

101

103

104

105

105

58.9 67.1 106 104 105

3.2 2.0 3.3 3.7

2.1 1.63 2.94 3.88

2.0 1.5 3.1 3.8

1.6 1.7 2.8 3.9

1.8 2.0 2.7 4.2

2.2 2.4 2.9 4.4

2.5 2.7 3.2 4.7

3.0 3.0 3.6 4.9

5.0 4.7 5.2 4.8

5.0 2.2 2.4 3.9 4.4 1.7 2.5 3.8 5.3 3.0 3.1 4.4 4.6 3.8 4.6 5.1

73 164 75

74 147 69

73 148 59

79 159 68

79 158 61

71 148 59

69 152 48

60 138 23

-7 -2 8

7 75 70 42 27 154 149 98 20 68 48 21

Credit Spreads (avg. basis points over Treasuries) 10yr AAA 72 136 191 10yr A 112 164 230 10yr BAA 148 204 281

199 232 276

242 281 316

257 300 330

252 295 324

245 286 315

238 278 306

231 270 297

Treasury Yield Spreads (avg. basis points) 5yr - 2yr 12 10yr - 2yr 35 30yr - 10yr 21

31 78 35

63 87 222 241 213 83 114 261 282 250 128 149 301 311 275

Forecast beginning in 2008.3

CAN Forecast Summary

% Change at annual rate

Year-over-Year % Change or Annual Average

History Forecast

2007.3 2007.4 2008.1

2008.2 2008.3 2008.4 2009.1 2009.2 2009.3 2009.4

2006

2007 2008 2009

2.3 4.2 4.5 8.1 20.5 -1.1 20.6 6.0 243

0.3 2.4 -2.3 4.5 8.4 -5.9 2.3 6.1 220

1.2 2.1 3.2 5.6 10.0 -2.3 4.4 6.1 191

1.7 3.1 3.2 7.9 9.3 -0.8 6.0 6.3 195

2.2 3.7 4.2 6.5 9.6 3.2 6.5 6.4 188

2.4 3.2 3.7 3.5 11.0 4.1 6.1 6.5 185

2.6 3.1 4.0 3.0 13.1 4.7 6.1 6.4 184

2.8 3.2 4.0 3.0 11.4 3.9 6.5 6.3 183

3.1 2.7 0.8 2.0 4.3 4.5 4.0 3.2 9.9 3.5 1.4 3.3 4.1 4.2 5.1 5.3 10.8 13.2 7.6 11.3 0.6 1.0 -3.9 1.5 4.6 5.5 3.2 5.8 6.3 6.0 6.2 6.3 229 228 210 185

Real CAN GDP and Components Gross domestic product Personal consumption expenditures Business fixed investment Government purchases Change in inventories ($ bill CAD) Exports Imports Unemployment rate % Private housing starts (thous. units)

0.8 -0.8 7.5 3.1 4.2 -1.2 5.0 3.3 20.6 2.9 -7.4 -4.1 8.6 -9.0 5.9 5.9 214 234

Prices 1.8

2.3

3.4

3.5

3.6

2.6

2.0

2.0

CPI-U excl. food & energy Foreign Exchange Rate USD/CAD

Consumer Price Index: CPI-U

2.2 0.96

0.0

2.4

1.6 1.4 1.02 1.00

1.5 0.99

1.5 0.96

1.8 0.94

1.9 0.93

1.7 0.92

1.7 0.92

1.7 0.91

CAN Interest Rates (avg. %) BoC Overnight Rate Ninety-day Treasury Bill Rate 3-month LIBOR 10-year Treasury Note Yield

4.50 4.25 4.87 4.46

4.42 3.92 4.92 4.18

3.00 2.55 3.42 3.75

3.0 2.4 3.4 3.6

3.0 2.4 3.6 3.7

3.0 2.6 3.6 4.0

3.3 2.8 3.7 4.2

3.6 3.1 3.8 4.3

3.8 3.4 3.8 4.5

3.83 3.01 3.92 3.79

2.0

2.1

2.0

2.3

1.5 2.1 1.7 1.7 0.88 0.93 0.97 0.92 4.1 4.0 5.2 4.2

4.4 4.1 4.6 4.3

3.2 2.6 3.6 3.7

3.4 3.0 3.7 4.3

Forecast beginning in 2008.2

2

North American Economic Outlook Fall 2008

Changes from the Summer Outlook For the U.S.: n

n

n

n

n

T he financial crisis is deepening, rather than improving, relative to our prior expectations. T he underlying trends expected in recovery remain unchanged. However, consumer spending is growing at a more sluggish rate; exports are less strong; and business investment a bit slower. T herefore, growth is much slower and we are now anticipating negative growth in the second half of 2008, followed by slower growth in 2009.

Since our Summer Outlook, the economy has been on the back burner while investors, policymakers and households reacted to tectonic financial events. Investors have been piling into treasuries, keeping yields near record lows. Consumers and businesses have been pulling back. Policymakers have nationalized several financial intermediaries, while Congress has devised big plans (TARP) to address the crisis.

T he Fed lowers rates by 50 bps before the end of this year. This is followed by a series of rate increases starting in the second half of 2009.

Do we think a rescue plan will help stabilize the markets?

Interest rates are lower, but as confidence returns they begin to increase, ending 2009 close to the levels in our last projection.

For Canada: n

n

Further ahead, we see the economy emerging from a shallow recession, led by lower commodity prices, cyclical fiscal stabilizers, consumer spending, strong exports and gradually improved business conditions. On balance, GDP is projected to be nearly flat to negative over the second half of the year before it posts a rebound to trend growth by the second half of 2009.

T he underlying trend remains the same although slower growth in 1H suggests slower overall 2008 growth. Less momentum in 2008 and a more sluggish economic activity now forecast for the U.S. also result in slower growth in 2009. E xport growth has taken a turn for the worse. The global slowdown and continued strength in the CAD have taken their tolls on export growth in the first half of 2008, forcing the re-emergence of positive growth back to early 2009.

(continued from page 1)

The U.S. outlook hinges on how consumer and business spending responds to the credit crisis The U.S. is still plagued by the housing slump and record financial losses, although 2008 economic growth has remained positive due mostly to expanding exports. Nonetheless, the economy is vulnerable to a demand downturn. Looking ahead, we now believe that the tension between the forces dragging down growth – housing, credit and inflation – will in the short run outweigh the projected stabilization in housing and credit conditions. Consumer spending is expected to decline under the weight of decelerating real disposable income, a weak job market, falling household wealth, and tightening credit conditions. Investment spending is also projected to decline under the weight of relatively wide credit spreads, de-leveraging, deflating asset prices, and the hit to corporations’ balance sheets as they absorb declining consumer demand and tighter profit margins.

Yes, even if we don’t like the details. We believe there is a significant risk that the longer it takes to get price-discovery for troubled bonds, and to get the credit markets unfrozen, the greater the risk that Wall Street’s problem will turn into a wider solvency crisis for the real economy. The immediate problem is that despite the huge sums of liquidity pumped into the system, inter-bank lending is frozen. As of October 1st, 3 month-libor yields reached 4.05% or 205 bps over fed funds. Against this background, Main Street cannot be immune to Wall Street’s woes. Time is of the essence and a systemic approach crucial, though we also believe that getting the plan more or less right is just as important. The challenge is to devise a plan that simultaneously protects taxpayers, re-capitalizes the financial sector, punishes foolish risky behavior, establishes an oversight mechanism, minimizes defaults and foreclosures, and restores confidence. The collateral damage to the real economy depends largely on how long credit is hard to get for businesses and consumers. If financial institutions now pull out all the stops and go for market solutions to their problems (and especially if they’ve quietly lined up some prospects already) it could all happen very quickly. But we are not counting on it, and the downside is substantial and alarming – home prices spiraling down, lenders and investors hanging back for months, while real businesses run out of working capital and lay off employees.

The U.S. outlook in brief: n

T he housing market is showing very tentative signs of bottoming. Starts, sales, prices, inventories and defaults remain on a downward trend, but at least the deterioration rates are gradually getting less negative. However, with the nationalization of Fannie Mae and Freddie Mac, we should see mortgage rates drop again compared to levels seen in the first half of 2008. We expect that prices will find a bottom by mid-2009, a time when more positive economic and demographic factors will lead the housing recovery. 3

North American Economic Outlook Fall 2008

n

n

n

n

n

n

n

n

T he job market is getting weaker as the unemployment rate has surged to 6.1% in September from 4.9% in January. We expect the unemployment rate to move up as high as 6.7%.

we are less sure that the credit markets will not experience extraordinary volatility. Therefore, our outlook is fairly optimistic, but highly unpredictable.

 ising joblessness will hurt spending and threaten to magnify the R economic drag from troubles in the financial and housing markets.

With inflation risks diminishing, the probability of rate reductions from the Fed over the next several months is high. The latest readings on inflation suggest that it will ease in the second half of this year. Overall, we anticipate that the drop in energy prices will take more pressure off headline inflation, while attempts by business and labor to recover lost profits and real wages will fail. However, we see an emerging deflation risk only within a scenario where the economy enters a deep and long recession underscored by a severe credit crunch. Instead, our base forecast implies that by mid-2009 the economy will be growing close to potential, helped by stable prices, a healing financial system, and more stable housing and labor markets.

 2 GDP saw 11.9% in real disposable income growth. Q However, given the very weak pre-rebate growth rate, the bounce from the stimulus checks will wear off in Q3. Inflation is expected to recede to 2% next year. Rising unemployment and asset deflation almost certainly precludes a cost-push spiral.  e project further Fed rate cuts before the end of 2008. The W Fed will then start tightening as soon as the ailing housing and labor markets start to heal in 2009. The Fed will continue to use non-traditional tools to stem financial paralysis. T he dollar has strengthened recently, bringing relief to import prices. The considerable slack that is emerging in the economy should aid the moderation in both core and headline inflation next year. Over the next year, the dollar is projected to remain within a current but gradual upward range as a relatively strong, based on stronger U.S. growth than in Europe and Japan with respect to its major trading partners begins to materialize. E xport growth has been the bright star during 2008 and the outlook is still for net exports to be a strong contributor to real GDP. An $85 billion improvement in net exports contributed 2.9% to Q2 GDP growth of 2.8%. The early third quarter figures suggest that net exports could again account for most of the 1% GDP growth in Q3.  s of October 1st, the passage of TARP or any similar package is A not a done deal. But even if such legislation fails, this would not mean that the government just bows out of crisis management. The Fed and the Treasury have effectively infinite amounts of money, and broad authority in an emergency. E stimates of the fiscal deficit have become less certain. To begin with, the Fannie & Freddie bailout implies that future defaulted debt (pick a number between $0 and $1 trillion, depending on the housing market) will now be on the taxpayers’ tab. The Congressional Budget office anticipates that a sharp increase in government spending will drive the federal budget deficit to a near-record $407 billion when the budget year ends later this month. This doesn’t include TARP estimates, or any more politically-palatable stimulus spending to support the economy.

In conclusion, in this brave new world, nobody can be certain that a rescue plan will prevent the economy from going into a slump, nor that a slump is inevitable without one. This is particularly true when much of what the rescue plan is trying to accomplish will depend on the details and its implementation. While we expect that some sort of lifeline will be in place soon,

Canada: Facing strong headwinds An economic road trip across Canada starts in the West with beautiful mountain views and commodity wealth, but Eastern Canada brings economic disarray, where at one time, its manufacturing-based export revenues underpinned Canadian economic growth. Income in the West is propping up Canada and its currency, but reduced real export growth is a serious risk. GDP contracted -0.8% annualized in Q1 and marked a puny +0.3% in Q2, which has sentenced Canada to a bleak 2008. Growth should pick up in 2009. In short: n

n

n

T he housing and labor markets are weak, but still look strong on a longer time horizon. With that, consumer spending will remain firm as long as commodity prices don’t fall through the floor.  educed commodity prices will hold the U.S. dollar R (USD) up relative to the Canadian dollar (CAD), providing new export demand for the ailing manufacturing sector. P olicymakers are frozen in the headlights of the oncoming elections.

Tight credit conditions have receded since Q1

% of respondants that have tightened or eased

n

Eased Tightened 45 40 35 30 25 20 15 10 5 0 Oct Apr Oct Apr Oct Apr Oct Apr Oct Apr Oct Apr Oct Apr 01 02 02 03 03 04 04 04 05 06 06 07 07 08

Source: Bank of Canada

4

North American Economic Outlook Fall 2008

 redit conditions have been relatively untouched by the C financial maelstrom in the U.S. Inflation is still in the pipeline and productivity gains are negative, so the Bank of Canada (BoC) will feel no need to reduce rates.

The housing and labor markets took a slight turn for the worse this year, but remain historically strong. The unemployment rate lingers around 6.1%, and housing starts are double their trough levels from 1996. Recent developments in housing and labor are more indicative of a cooling off than a high-impact crash. However, weakening labor and housing markets have not slowed 2008 business and personal net worth growth, which accelerated to 2.8% in Q2, following a weak but positive 0.7% in Q1. Going forward, weaker housing wealth accumulation and softer wage income gains in 2008 and 2009 may slow spending relative to 2007. However, we expect consumption growth to re-emerge in 2009.

With a healthy housing market... 290 250 210 170 130 90 Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jul 1998 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 Source: Statistics Canada

…and the jobless rate hovering at historical lows... 13 12

Canada holds its Parliamentary election on October 14th and we do not expect the Department of Finance to entertain the idea of further expansionary measures – beyond the already enacted GST (Canada’s value-added tax) cut earlier this year – before then. The unexpected drop in economic growth over the first half of 2008 will be a primary topic of debate, given the influx of commodity-based capital flows. In the event that weak growth passes through to tax receipts, a budget deficit might materialize, which would also spark debate. However, we attach a low probability to a 2008 deficit, given the recent surge in commodity-based corporate profits and the current Administration’s tight fiscal policy goal.

Unemployment rate (%)

The primary risk to the outlook continues to be the shrinking real trade balance, stemming from a strong CAD that is hovering around its 30-year high. On the upside, the CAD has kept core inflation low, but with a struggling U.S. economy, policymakers are concerned about exports. On the other hand, the recent drop in oil prices is strengthening the USD (currently trading above its 100-day average against the CAD), which bodes well for export volumes in the second half of 2008. We believe that oil prices in the $100/barrel range will maintain the upward bias on consumption growth, but keep the CAD low enough to induce additional export momentum.

The BoC stands ready to inject liquidity into its credit markets if needed. However, barring any unforeseen and negative shock to the financial system, we believe that the central bank has been appropriately accommodative. We expect that the BoC will remain on hold throughout 2008, and when the economy regains strength in 2009, initiate a series of rate hikes. Consequently, the yield curve will get steeper due to relatively bigger rate changes in the long end than in the short end of the curve, as stronger economic footing serves to calm nervous investors.

Total Starts (thousands)

n

Financial markets in Canada are calmer than in the U.S.

…consumption expenditures are still growing at a solid pace

10 9 8 7 6 Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jul 1998 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Source: Statistics Canada

Consumption growth (% q/q annualized)

On the positive side, Canada seems largely immune to the credit hurricane that has ripped through the U.S. and Europe. According the bank loan survey, strict credit standards peaked in Q1, when 40% were tightening their lending standards, and have come down to just 29% in Q2. The availability of bank credit remains within reach of its 8-yr average, 8.5%. Admittedly, credit has slowed slightly, growing 8.1% annually in July, which is below its January peak of 14.9%. However, in response to global financial unease, there has been some flight to safety on the front-end of the yield curve, but nothing like the 100-meter dash in the U.S.

11

8 7 6 5 4 3 2 1 0

Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr 05 05 05 05 06 06 06 06 07 07 07 07 08 08

Source: Statistics Canada

5

North American Economic Outlook Fall 2008

The BoC will not throw caution to the wind. Three nasty quarters of negative productivity growth will keep policymakers on high alert, as productivity gains serve to buffer inflation pressures. On the upside, second quarter manufacturing productivity grew for the first time since Q3 2007, and business productivity surged. The declines are still centered in the mining, oil and gas extraction, and construction industries.

of a lifeline to AIG (albeit an expensive one), and the demise of Washington Mutual first and then Wachovia. The stage was set for the largest ever government intervention in the financial sector, as the growing credit crisis combined with the political timetable to generate overwhelming pressure. Conservatives and liberals alike could object and stall, but – in the words of Star Trek – “resistance is futile”.

In conclusion, our forecast is benign, but risks are everywhere. First, growth seems for now to be at the mercy of commodity prices. With manufacturing not expected to return to full capacity any time soon, Canada’s consumption depends on labor income in the mining, petroleum, and retail sectors. It is essential that robust commodity revenues continue to drive consumption at a rate that outpaces the manufacturing sector’s weakening of it. Second, another surge in commodity prices, while drawing strong revenues and growth, would lead to unwanted strength in the CAD, and further downward momentum in manufacturing exports. In either scenario, economic growth is weaker than our current forecast of 0.9% in 2008, which depends on a careful balance of the CAD; not too strong to discourage exports, but not too weak to kill recent commodity-driven gains in consumption demand.

…or is it? On September 29th, the TARP bill went down to defeat in Congress, the U.S. stock market plunged 7% in one day; and while further attempts will undoubtedly be made to enact the big rescue package, markets were left with the cold realization that they might be on their own.

The turmoil in financial markets rages unabated. A precipitous loss of confidence in the big semi-private mortgage institutions led to the nationalization of Fannie Mae and Freddie Mac early in September. Market speculation immediately swirled as to who would be next: Lehman Brothers, Merrill Lynch, Washington Mutual, AIG, General Motors, Wachovia…? – or all of the above?

Attempting to let market discipline run its course… Rumors of imminent failures gave time for all players to think about their next moves. Whereas Bear Stearns had failed without widespread preparations, and whereas Fannie and Freddie were serving a quasi-public purpose, it appeared that the next round of failures could be left for markets to cope with by themselves. With the unassisted demise of Merrill and Lehman, the debate about moral hazard in an age of government intervention seemed to be resolved in favor of placing financial risk back into the lap of the risk-takers.

…but the system as a whole is “too big to fail” In the event, the ramifications of Lehman’s failure were more destabilizing than expected to the flow of credit. A crisis of confidence led to the conversion of Goldman and Morgan Stanley to regulated bank holding companies, the extension

The misery index is surging… Inflation (CPI) + Unemployment rate

Credit Markets: turmoil, bankruptcies and bailouts – moral hazard vs. depression?

The rejection of one proposal would not put the government out of the crisis management business. The Fed and the Treasury still have broad authority in an emergency. Liquidity can be turned on without limit in the event of bank runs, with direct lending to any firm deemed critical (probably any Fortune 500 company). In addition, it’s never too late to craft direct support for the economy in a more politically palatable form (e.g. credit lines for state and local governments; “rebates” to individuals).

25% 20% 15% 10% 5% 0% 4/1/60

4/1/72

4/1/84

4/1/96

4/1/08

Source: BLS and Economic research

…But a drop in projected inflation should offer relief to consumers facing rising unemployment CPI (qoq annual); Unemployment rate

U.S. Financial Markets

The Fed & Treasury would not be disabled even if TARP were defeated

Unemployment rate

Inflation (qoq)

8% 6% 4% 2% 0% -2% 1/1/06

10/1/06

7/1/07

4/1/08

1/1/09

10/1/09

Source: BLS and Economic research; Projections from Q308-Q409

6

North American Economic Outlook Fall 2008

Monetary policy: creativity as well as rate cuts

Equities: looking ahead to economic recovery

Conventional monetary policy – adjusting the federal funds rate – has been on hold. But that doesn’t mean the Fed is on the sidelines. By shifting the market’s expectations through public statements, new lending facilities and direct interventions, policymakers are trying to avert the death-spiral that could ensue if financial institutions become too fearful to lend at all. So far their efforts have been worthwhile, even if the effects remain to be seen. Further rate cuts now seem likely too, both to boost bank profits and to rebuild confidence in the economy.

Equity markets have been battered both by financial market storms and by real economic weakness in the housing and consumer sectors. Three key questions are therefore when investors’ appetite for risk will return, whether the housing market is close to a bottom, and whether consumers will keep spending.

Wider credit spreads, but the real issue is availability: the SEC rides to the rescue Despite sharply wider credit spreads, tight credit standards, and bank losses that outpace new capital raised, published data still shows rising total bank lending. Right now, however, short-term credit has probably dried up for those without existing lines. There may still be plenty of liquidity in the world, but it will take time to rebuild bank capital; and dramatic shifts in financial market share may take a serious toll on the ability of businesses and consumers to find a willing lender in the short run. Even if the TARP program enables government to offer banks good assets for bad, it’s impossible to know how much damage may be done to the real economy in the process. In this context, the SEC’s “clarifications” on fair value accounting released on September 30th may be as important as the rescue package before Congress. This shift has the potential to short-circuit the downward spiral from illiquidity to insolvency. Fire-sales by troubled bond-holders into frozen markets should no longer force healthy banks to write down their assets and thus their lending capacity.

U.S. dollar: relatively strong for now, weaker in the long run The U.S. exchange rate was boosted during August by the relative strength of U.S. economic news compared to that from Europe and Japan. Even China shows hints of stress, and the faint light at the end of the U.S. tunnel looked promising by comparison. The latest turmoil has brought volatility rather than any clear reversal.

All three of these unknowns are related to virtually unprecedented cycles in credit, housing, and consumer finance. Calibrating a forecasting model to unprecedented inputs is essentially impossible, leaving the answer to each question to as much art as science. We believe that credit will soon be available – at a price – for viable borrowers, and that the search for yield by global investors will rebuild bank capital and lending capacity. We estimate that the housing sector is close to a bottom in terms of building and sales, though prices clearly have further to fall. And unless consumers suddenly ramp up their saving, the normal forces of income growth will drive spending upward as soon as the job market stabilizes. Given this fundamentally optimistic outlook, the equity market is expected to look through the current turmoil to the recovery beyond, as it has in past cycles. Persistent doubt about when the job market and the real economy will in fact turn around may delay this rebound, but we believe that the prospect of resumed normal economic growth will soon overwhelm the current market gloom.

Bond rates: recession and a flight to quality drove bond rates lower, but both will reverse The combination of economic weakness and investors’ flight to quality as financial confidence unraveled has driven bond rates down close to recent historical lows. As credit markets heal, and renewed lending supports renewed economic growth, both of these forces will be rapidly reversed. In the current climate there is, of course, deep disagreement about when this turnaround will arrive, but we believe that by the end of next year U.S. bond rates will be about 100 basis points above today’s level and still rising.

Despite this strength, however, the USD remains well below its level a few years ago, and U.S. goods and services still appear generally cheap to foreign buyers. U.S. producers have been able to increase their market share, shrinking the trade deficit and contributing the lion’s share of recent GDP growth. In the long run we expect further weakening as the reversal of the overall trade imbalance still has a long way to go.

7

North American Economic Outlook Fall 2008

Risks

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Overall, the de-levering process continues. Despite huge infusions of liquidity, banks are keeping their cash in vaults, and the price discovery mechanism to value assets is not working. We were expecting calmer markets by now, but both bond and equity prices are being driven by a total lack of confidence. The longer the fear persists, the greater the risk that the financial turmoil infects businesses and households.

The no rescue-plan scenario: optimism is possible Much has been said about the need for a bailout plan, but with a political stalemate in Congress, nothing may get approved. In the current climate of fear it seems a gamble, but it may be no riskier than the bailout itself. An optimistic view: n

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 arkets may go down, but as market forces take over, M domestic and foreign buyers take advantage of low prices to buy distressed assets and re-capitalize the financial sector.

S tarting with less risky credits, financial institutions begin to part with their cash.  onsumers adjust to their expected “permanent income”, not C letting current shortfalls impact their spending materially. The economy may go through a recession, but recovers within a year.

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T he troubled credit held by banks is bought at a higher price than available in the market today, and taken off balance sheets so banks can attract new capital and start to lend again.

Bill Cheney — Chief Economist MFC Global Investment Management Telephone: 617-572-9138 Email: [email protected]

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T he proposed plan is unable to smooth a reduction in mortgage balances to market prices and refinance them to lower mortgage payments. The process takes too long and other financial crises emerge.  ost of the $700 billion is spent without reviving market M confidence, with large losses for taxpayers. T he economy goes into a deep recession as domestic spending dries up. Unemployment goes above 7%, the dollar sinks, U.S. assets go to foreigners at fire-sale prices, and the U.S. fiscal deficit balloons. Think Japan, but without the trade surplus. T he moral hazard created by the government bailout distorts the financial system for years to come.

The truly ugly scenario Even worse outcomes are projected by pessimistic forecasters, such as NYU’s Nouriel Roubini. In this scenario the U.S. loses a decade, like Japan in the 1990s: n

In this scenario, after an initial $100-$300 billion infusion, confidence rebounds, financial markets stabilize, and the economy gets moving again:

T axpayers end up with a small bill or even a profit. Future Administrations address budget deficit by either increasing taxes or cutting down on spending.

In this scenario, there is no financial meltdown, but the economy is in intensive care for quite some time as the financial sector heals. Broadly:

 ealthier banks, from JP Morgan and Bank of America right H down to your local community bank, gain market share from those whose capital has evaporated.  n asset-deflationary period is sharp, but temporary, as A winners and losers quickly adjust to their fates.

 ousing prices are close to bottom and excess inventories H gradually decline.

The bad scenario: the TARP is not enough

T he system is strengthened by eliminating the moral hazard of expected government protection.

The good scenario: TARP passes and works as planned

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T he economy remains vulnerable to a contraction but gradually regains its footing over the next year. Unemployment peaks at about 6.7%.

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 omes prices fall further, bringing yet another wave of H mortgage losses. Equities decline and stay down for years. T he 6.1% unemployment rate hits 8% early next year and peaks at 15%. T he budget deficit surges, interest rates jump, inflation gets out of control, and the dollar sinks.

Oscar Gonzalez — Economist MFC Global Investment Management Telephone: 617-572-9572 Email: [email protected]

Rebecca Braeu — Economist MFC Global Investment Management Telephone: 617-572-0868 Email: [email protected]

MFC Global Investment Management

MFC Global Investment Management® (MFC GIM) is the asset management division of Manulife Financial. The MFC GIM diversified group of companies and affiliates provide comprehensive asset management solutions for institutional investors, investment funds and individuals in key markets around the world. This investment expertise extends across a full range of asset classes including equity, fixed income and alternative investments such as oil & gas, real estate, timber, farmland, as well as asset allocation strategies. MFC GIM has investment offices in the United States, Canada, the United Kingdom, Japan, Hong Kong, and throughout Asia. As at June 30, 2008, assets managed exceeded C$230 bil. (US$230 bil.) The information contained herein is based on sources believed to be reliable, but it is neither all-inclusive nor guaranteed by MFC GIM. Opinions and forecasts reflect our judgment at the time of publication and are subject to change.

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