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Global turmoil threatens Canadian earnings Add to ...

Investors are anxiously awaiting this week's initial burst of Canadian third-quarter earnings reports to see if the global economic storm has exposed chinks in this country's corporate armour.

Nearly 20 per cent of the companies on the S&P/TSX composite index are scheduled to release their results this week – by the end of which the trend in profit growth should be clear.

While the better-than-expected earnings season that's already in full swing in the United States provides reason for optimism, the Canadian market is acutely exposed to commodity prices and the financial sector – the parts of the global economy feeling the most pain from the debt crisis in Europe and slowing growth. Any shortfall in third-quarter earnings could translate into a rude awakening for investors.

“Canadian earnings are more susceptible to disappointment than are U.S. earnings,” said Vincent Delisle, market strategist at Scotia Capital in Montreal.

For Canada's biggest publicly traded companies, earnings expectations have already fallen dramatically from where they were a few months ago.

According to financial-market research firm FactSet, equity analysts are calling for third-quarter earnings for Canada's blue-chip S&P/TSX 60 index to grow by 29.8 per cent from a year earlier – more than double the profit growth expected of the S&P 500 in the United States.

But that number is down from 36 per cent when the quarter ended just three weeks ago, and from more than 50 per cent when the quarter began in July.

The reason for the dramatic downward revisions is the Canadian market's heavy weighting toward commodity and financial stocks.

The energy, materials and financial sectors make up more than three-quarters of the S&P/TSX composite, compared with less than 30 per cent of the S&P 500.

Stronger commodity prices this year have provided a much bigger boost to earnings in Canada than in the U.S., but worries over slowing economic growth have weighed on raw material prices in recent months.

Meanwhile, some big charges taken in the 2010 third quarter by Manulife Financial Corp. and Sun Life Financial Inc. make for favourable year-over-year earnings comparisons for the Canadian financials, the single biggest sector on the S&P/TSX. However, the European debt crisis, weak capital market activity and concerns over household debt levels cast a shadow over the industry.

While earnings expectations have retreated among the big names on the S&P/TSX 60, the pullback is much less evident in the broader Canadian market, as analysts covering smaller Canadian stocks have been slower to cut their estimates. Third-quarter profits for the 258-stock S&P/TSX composite are expected to grow by more than 40 per cent from a year earlier, according to data compiled by Bloomberg - and those expectations have come down only slightly over the course of the third quarter.

"That puts Canadian earnings in jeopardy," said Mr. Delisle.

But George Vasic, chief economist and chief strategist at UBS Securities Canada Inc., said the declines in Canadian stock prices in recent weeks already reflect the falling commodity prices that are likely to have weighed on energy and materials profits.

"The market trades on forward earnings anyway - that's what really matters," he said.

Alec Young, global equity strategist for Standard & Poor's in New York, argued that Canada has a relatively healthy outlook for 2012 earnings, compared with the world's other developed markets - and that's reflected in the price of Canadian stocks. The S&P/TSX composite trades at more than 13 times estimated earnings for the next year, compared with 12 times for the S&P 500 and less than nine times for the Euro STOXX 50 index.

"It's a premium valuation, and that's because it has premium earnings momentum," he said.

The biggest risk for Canada's earnings outlook is how well commodity prices - especially oil and gold - will hold up.

"These are the big wild card," Mr. Vasic said. "These two prices affect 35 per cent of the TSX."

And, Mr. Young said, the biggest threat to commodity prices is the debt crisis in Europe, which has the potential to derail global economic growth. As a result, he said, any good news out of this earnings season will take a back seat to news from the euro zone.

"It's been a good earnings season, but in many ways, it really doesn't matter. That's frustrating," he said.

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