It's pretty much a given that a growing economy is good news to the stock market, but Canada's current economic surge must be particularly encouraging for Canadian stocks. Why? Consider one of the key sources behind that growth.
Statistics Canada's first-quarter GDP report, released Monday, showed that corporate profits - the foundation on which stock values are built - surged 8.6 per cent in the quarter, accounting for more than one-third of the GDP rise on an income basis. Its share of last year's fourth-quarter GDP jump was about the same.
Given that corporate profits represent only about 13 per cent of total GDP, the segment has clearly been hitting way above its weight as a driver of the Canadian economic recovery. And while some of the data imply that the best of the profit boom may already be behind us, other details suggest we may have seen only the tip of the iceberg as far as stocks are concerned.
A RETURN TO PROFIT PEAK - FOR SOME
Statscan's numbers show that despite the surge over the past two quarters, corporate profits are still more than 20 per cent below their peak of the 2008 third quarter. However, notes National Bank Financial economist Marc Pinsonneault, operating profits excluding the energy and financial sectors - two groups that were particularly battered by the downturn - are now a mere 2 per cent from their precrisis peak.
That's a significant base of growth for the broad Canadian economy, because non-financial, non-energy companies account for roughly two-thirds of Canada's corporate profits. However, the financial and energy sectors are heavily overrepresented on the stock market itself, making up 57 per cent of the S&P/TSX composite index's total weight.
That means that the two sectors that have been lagging in Canada's corporate-earnings-recovery story are the ones that make up the bulk of the stock market, which may help explain why stocks have had trouble maintaining their momentum even as the economy picks up speed. However, the silver lining is that the greater part of the stock market still has plenty of growth potential ahead of it as these two lagging sectors catch up with the broader economic recovery.
Meanwhile, even one of the biggest and fastest-growing market segments in terms of profits may still have more upside.
Manufacturing operating profits jumped almost 13 per cent in the first quarter. National Bank's Mr. Pinsonneault notes that this came as profit margins surged to 5.7 per cent in the quarter - despite a strong Canadian dollar that was supposed to have cut into profits for the export-oriented Canadian manufacturing sector. Some of this margin recovery is, no doubt, a function of the substantial job cuts in the sector during the recession.
Despite this margin recovery, though, Canadian manufacturers' profit margins are still far below those of their U.S. counterparts and their own historical peaks, and have yet to recover to prerecession levels. While that gap may reflect the lingering impact of the stronger currency, it may also be evidence that manufacturing profit margins have room to continue to climb.