By Douglas Porter, CFA, Chief Economist and Managing Director, BMO Financial Group

The North American and global economies performed much better than widely expected in 2025, despite a seeming unending wave of geopolitical uncertainty and policy noise. In turn, financial markets surprised to an even greater degree, with global equity markets cruising to record highs even after a nasty spill in the early spring amid the trade war. Lower interest rates, fiscal policy support, and the ongoing boom in spending on AI infrastructure all help the economy hurdle the trade war. The pressing question for 2026 is whether we can see a repeat, with the geopolitical noise ramping up even further so far this year.

Beginning with the United States, despite accelerating 4.4% annualized in the third quarter of last year, real GDP growth likely moderated to an estimated 2.3% rate in 2025 from 2.8% in 2024. The effects of the trade war, federal government cuts, and immigration curbs more than offset rapid AI- driven business spending, record equity values, and stimulative regulatory and monetary policies. Still, the economy outperformed expectations last year and growth looks to remain solid at 2.6% in 2026 as AI tailwinds persist while headwinds subside.

On the tariff front, the second half of 2025 brought some relative stability, though little clarity on policy direction. The Supreme Court could rule that the international emergency duties that account for the majority of new tariffs are illegal. But this would only partially curb the Administration, and largely result in new duties under other trade acts. The USMCA will be reviewed this year and we assume talks will extend at least into next year. We also assume the U.S. will extend a one-year trade truce with China, averting a sharp rise in tariffs between the two countries.

Easing headwinds will allow prevailing tailwinds to dominate in 2026. Big Tech plans to boost spending on AI infrastructure (data centres, chip plants, and even energy sources to run it all), while other businesses are investing heavily in AI systems to drive productivity. Whether AI spending can deliver a meaningful productivity payoff will likely determine whether the equity rally continues or corrects.

In addition, the Federal Reserve probably isn't finished easing after trimming the funds rate by 75 bps in 2025. True, with the policy rate close to a neutral range, divisions are hardening within the FOMC over whether more cuts are needed to address labour market weakness or whether to pause and assess progress toward the inflation goal. While annual CPI inflation fell to 2.7% in December and the core rate dipped to a near five-year trough of 2.6%, shutdown-related distortions likely aided the moderation. Meanwhile, employment growth, though still weak with nonfarm payroll rising just 50,000 in December, is showing signs of stabilizing.

We believe the FOMC will resume trimming rates in the spring. The current jobless rate (4.4%) could average 4.6% this year, above the FOMC's neutral estimate (4.2%). Moreover, Chair Powell's replacement in May is widely expected to lean dovish, even as the incoming voter rotation skews hawkish, setting the stage for more policy dissents. Subsequent rate cuts in June and September would take the mid-point of the policy rate range down to 2.875% by the fall. However, questions

about the Fed's independence, alongside firm economic growth and a large federal budget deficit, could keep the 10-year Treasury yield at or slightly above 4% this year.

Turning to Canada, the best that can be said about the economy in 2025 is that it likely skirted a recession, thanks to the duty-free status of USMCA-compliant goods, supportive fiscal and monetary policies, and the TSX's blistering 28% rally. Still, real GDP growth likely slowed to 1.7% from 2.0% in 2024. Moreover, the annual average figure likely understates the true deceleration in activity, with GDP likely rising just 0.8% on a Q4/Q4 basis after surging 3.1% in 2024. We expect stronger 1.8% growth in 2026 (Q4/Q4, or 1.4% annual), assuming no nasty surprises on the trade front.

Our critical assumption for 2026 is that the USMCA review will extend beyond this year, keeping the

U.S. in the Agreement and preserving the compliance exemption on most Canadian goods. Potential issues for discussion include supply management and the Online Streaming and News Acts. The review could lead to a reduction of some sectoral duties, notably the 50% import tax on steel, aluminum, and some copper products, trimming the U.S. average tariff on Canadian imports from its current level of around 7%. Apart from a few hard-hit industries, the economy will largely adjust to the lower level of exports. Ongoing uncertainty, however, could cast a longer shadow on business confidence and investment. The impact of a USMCA breakdown would be far worse, potentially spiking the average tariff rate and triggering a moderate recession in Canada, even with significant policy support.

Stimulative fiscal policies at both the federal and provincial level should continue to cushion tariff effects in 2026. Combined deficits are projected at near 4% of GDP this fiscal year, or more than 2 percentage points above FY2024/25. Federal initiatives aim to jump-start investment by accelerating infrastructure, mining and energy projects, while reinstating full and immediate capital expense deductions and supporting tariff-impacted industries.

The economy will also benefit from last year's 100 bps of rate cuts from the Bank of Canada. However, with rates now at the low end of neutral and inflation still moderately above target, the easing cycle is probably over. Nevertheless, we don't see the Bank reversing gears this year.

Although employment, as measured in the household survey, has rebounded strongly after contracting last summer, ongoing weakness depicted in the establishment survey likely better reflects reality.

Home price risks remain contained to Ontario and British Columbia, where affordability remains weak. The Toronto area faces extra price risks from a glut of unsold condos and a surge in purpose- built rental construction, made worse by meaningful immigration curbs. However, so long as mortgage rates remain near neutral levels and the jobless rate holds relatively still—we see the current 6.8% rate peaking at 7.0% before declining—home prices in the two provinces should stabilize this year. Elsewhere, prices could climb modestly, with regions currently seeing outsized gains, such as Quebec City, St. John's, and Moncton, reverting to more normal increases.

After rising moderately against a weak greenback in 2025, the Canadian dollar is expected to appreciate further to C$1.33 (US$0.75) by year-end as Fed rate cuts compress bond spreads in the two countries. Just don't expect it to travel a straight line until the USMCA drama is settled. Another

currency risk is that U.S. influence in Venezuela could lead to more oil exports to the U.S., displacing some Canadian sales over time while lowering crude prices.

The main risk to Canada’s economy stems from its tenuous relationship with its largest trade partner. Tensions recently rose when the President threatened a 100% tariff on all Canadian goods if the country makes a ‘deal’ with China. This follows Canada and China agreeing to reduce tariffs on some Chinese EVs and Canadian canola products. Presumably, ‘deal’ means a free-trade deal, which Canada has already ruled out (and would be a violation of the USMCA), so the threat is unlikely to materialize.