Welcome to PIMCO’s inaugural “Canadian Perspectives,” a quarterly look at Canada’s economy and financial markets. In future articles, I’ll explore specific aspects of the Canadian economy and bond market, but in this first edition, I’d like to focus on the outlook for 2007. The 2007 outlook for Canada’s economy and financial markets hinges on the push and pull between two key factors, one external and one domestic: the external influence of slower U.S. and global growth, and the domestic influence of rising housing prices and consumer spending. The Canadian economy is very open to trade, and is thus highly exposed to slower growth among its key trading partners—the U.S., in particular, but increasingly China and the rest of the world. While Canada faces external risks from slower global growth, the robust Canadian housing market, sturdy employment, steady business investment and the potential for higher government spending offer a potential offset. Taken together, in PIMCO’s forecast, these internal and external factors should add up to real Canadian GDP growth of approximately 2.0% over the next 12 months. This is 0.50% lower than the most recent 2007 forecast by the Bank of Canada. Our lower growth forecast is primarily based on PIMCO’s view that the U.S. economy will slow to a greater extent than the Bank of Canada expects, as well as our view that a slight weakening of domestic final demand is likely after the exceptionally strong levels experienced over the past few years. The Bank of Canada sees the current stance of monetary policy as appropriate for an economy experiencing a modest slowdown, which it expects

Serious macroeconomic thinking is a hallowed tradition at PIMCO. And over the last decade or so such thinking has been truly serious only if it has been global. We’ve taken up that challenge with gusto here at PIMCO, alongside the globalization of our business. Our Secular and Cyclical Forums don’t just have a global flavor, but are now dominated by global considerations. Along the way, we’ve added many, many talented investment professionals, deepening and broadening our understanding, both enabling and forcing us to anticipate, rather than react to secular and cyclical developments outside the United States.                         In this vein, we were delighted to have Ed Devlin join us last year as Senior Vice President and Canadian Portfolio Manager. Ed, a Canadian, has more than 16 years of experience in global finance, having worked in London, Tokyo, New York and Toronto, with several of the world’s foremost financial management firms: Lehman Brothers, Merrill Lynch & Co., Goldman Sachs & Co. and Andersen Consulting. Ed co-chairs our cyclical Canada Forums along with Margaret Isberg, the President of PIMCO Canada. A graduate of Wilfrid Laurier University and the Tuck School at Dartmouth College, Ed brings a deep understanding of the Canadian economy to PIMCO’s portfolio management team.       Enjoy!   Paul McCulley William Powers Managing Directors

to return to trend growth in 2008. We at PIMCO forecast that the Bank will be forced to cut rates in the second half of 2007 to help the economy return to trend growth. We expect the U.S. Federal Reserve to cut rates after the first quarter of 2007, and that the cumulative rate cuts in the U.S. will be greater than those in Canada this year.

Internal Strength

The Bank of Canada continues to see robust domestic final demand where the upside risk to the economy is momentum in consumer spending (see Chart 1) and housing prices. Canada’s housing market has better fundamentals than the U.S. housing market. Housing starts have stabilized at relatively healthy levels and while we expect a slight moderation of this trend in the second half of 2007, in general we do not see starts weakening significantly in 2007. However, housing prices, which have been skewed by the strong Western markets, are starting to moderate, with prices in the Central and Eastern provinces only growing in the low single digits and signs that prices in Western markets are beginning to decline from their very lofty levels. Thus, we forecast the upside risk of housing price increases as limited, and expect growth in prices to slow in 2007.

The Bank of Canada sees a modest deceleration in consumer spending in 2007 with the risk that consumer spending could surprise to the upside. We at PIMCO do not forecast that this upside risk will transpire. The Canadian consumer is employed and enjoying the benefits of housing price gains, low interest rates and a terms-of-trade shock (as commodity prices and the Canadian dollar have risen, Canada has been getting more for its exports and paying less for its imports). Canada’s housing market does not facilitate the large-scale withdrawal of mortgage equity that has been a key driver of U.S. consumption over the past five years. Net, the Canadian consumers are not as over-leveraged as their American counterparts, and face better employment prospects as the construction industry is not to contract as much as the U.S. Hence, consumption will likely hold up better in Canada than in the U.S., but will moderate and not accelerate as feared by the Bank of Canada.

Government spending is one area where PIMCO forecasts growth in 2007. The current Conservative minority government has pledged to reduce net debt as a percent of GDP to 25% by 2012-13, but several factors suggest the government will increase fiscal spending in 2007, primarily through tax cuts. First, after years of accusing the Liberals of purposely underestimating the fiscal surplus, the 2006-07 surplus of $7.2 billion announced on November 23rd was $3.6 billion more than projected in the May 2006 budget. Second, the recent decision to tax income trusts was not motivated by revenue raising considerations; it was about fairness in tax policy and preserving a functioning equity capital market. Finally, the likelihood of a Spring General Election should result in plenty of pre-election goodies (especially, for the Quebec voters).

Business investment should continue to chug along at a healthy pace as corporate profits remain robust (although we do not forecast an acceleration). Investment in the energy sector will continue while capital expenditures in the manufacturing sector should continue to suffer from the hollowing out of Central Canada.

External Weakness
What about the rest of the world? Currently, exports account for about 36% of Canadian GDP, and 80% of Canada’s exports go to the U.S. Thus, Canadian growth is highly sensitive to developments in the U.S. and global growth.

PIMCO believes the most likely scenario for the U.S. in 2007 is that growth will remain below trend at about 2%, owing to the influence of the ongoing housing market correction and its expected impact on the labor market and consumer spending. China is Canada’s second largest trading partner and the second largest importer of Canadian commodities. Chinese policymakers are taking steps to slow the investment boom currently underway and the economy is showing signs of a modest slowdown. However, PIMCO does not expect a hard landing in China and China’s growth as a consumer of commodities, and the growth of other emerging markets, may maintain pressure on commodity prices even as the U.S. slows. In the Eurozone, recent above-trend growth is expected to give way to trend-like growth of about 2% next year, as the economy faces a number of headwinds.

That should all add up to a soft landing for U.S. growth and the global economy after the strong growth of the past few years. But we see the risks as skewed to the downside in the U.S., owing to the potential for a sharper-than-expected slowdown in housing that spills over into other sectors of the U.S. economy and slows consumer spending (see Chart 2). While we believe the rest of the world can take in stride a U.S. soft landing, a harder landing in the U.S. creates the potential for greater spillover effects and a harder landing for the global economy.

The potential for a harder landing for the global economy presents risks for Canadian growth for two reasons. First, a global hard landing would likely decrease demand for energy, and energy exports have been increasingly important to Canada’s growth. Second, Canada’s growing trade with other countries, and growing exports of commodities other than oil, mean the Canadian economy is likely increasingly sensitive to global growth.

Monetary Policy
What does all of this mean for Canadian monetary policy? Canada’s close links with the U.S. means that it is nearly inevitable that the Canadian economy should slow along with our neighbor to the south. In 2006, the Bank of Canada has been forward-looking in pausing ahead of the Fed and leaving rates at 4.25%, 100 basis points below the Fed (while both are looking at virtually the same measure of core inflation, 2.2%-2.3%). Even so, the Bank of Canada’s growth forecasts proved too optimistic for 2006. And while the Bank of Canada’s concerns about strong growth and pressure on resource utilization feeding into higher inflation have receded during this period of below trend growth, we think the Bank’s forecast for 2007 growth will also turn out to be too optimistic.

Historically, the Bank of Canada has also shown a willingness to look through core inflation that it judges as “temporarily” above the midpoint of its 1% to 3% target. In 2006, the Bank showed that it is not willing to act based on any single data series, but is looking for a clear trend before changing monetary policy. Thus, we expect the Bank of Canada to cut rates as the economy slows, but the Fed is likely to move first and further in easing monetary policy.

Investment Strategy
Given the baseline of a soft landing for the U.S. and global growth, with risks skewed to the downside and particularly so in the U.S., Canadian portfolio management calls for positioning for the most likely outcome while taking insurance against the tail-risk.

The most likely outcome, given our baseline, is a decline in interest rates led by the U.S. This should translate into an overall bullish stance on duration, with a preference for U.S. duration over Canadian duration. Simply put, there is more anticipated downside economic risk in the U.S. compared with Canada and so more upside potential for bonds.

In terms of curve positioning, the likelihood of central bank rate cuts favors the two-year sector relative to the belly of the curve (the five- and 10-year sectors). We also expect the long end of the Canadian curve to benefit from asset-liability management flows from pension funds and insurance companies seeking to hedge their very long-duration liabilities with long-duration bonds. This asset-liability management trend is already well underway in Europe, and to a lesser extent in the U.S., due to regulatory and accounting changes, but is only now beginning in Canada. In 2006, Canadian subsidiaries of European and British companies began extending their Canadian duration to keep consistent with the policies of their European parent companies. In 2007, we expect the pace of these asset-liability flows to accelerate as Canadian accounting standards for life insurers will converge towards international standards with the introduction of fair value accounting. In addition, Canadian subsidiaries of U.S. companies may also extend duration of assets given the changes to U.S. pension accounting standards (FAS 158) that now require corporations to recognize the funded status of the plan on the balance sheet. In an effort to reduce the volatility of the balance sheet, sponsors may seek a better match between the interest rate sensitivity of their assets and liabilities.

The Canadian dollar’s four-year bull market—fueled by Canada’s strong domestic fundamentals, rising commodity prices and large merger-and-acquisitions flows into Canada—appears to have run its course. As we look into 2007, the loonie appears overvalued on a purchasing-power parity basis and vulnerable to a U.S. slowdown. Bank of Canada Governor David Dodge has noted the risk of a disorderly resolution to global trade imbalances (which would benefit the loonie as Canada runs a current account surplus), but we agree with him that this risk is remote. Thus, in the baseline case of a soft landing for the U.S. and the global economy, the Canadian dollar is likely to weaken, as it always has during U.S. economic slowdowns. In the event of a hard landing in the U.S., the Canadian dollar is likely to weaken more sharply. Over a secular horizon, with globalization driving commodity prices higher, and Canada benefiting from its greater fiscal situation, we see the loonie making parity with the U.S. dollar, but not in 2007.

Edward Devlin
Senior Vice President
edward.devlin@pimco.com
January 12, 2007