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The Canadian economy continues to draw crowd-pleasing performances out of its long-running, two-trick magic act. Resource producers and banks combined to account for more than half of the total profit and nearly a third of revenue chalked up in 2011 by the 1,000 largest publicly listed companies. No other sector came close. But even as these traditional creators of wealth extend their multi-year dominance in Canadian corporate life, their throngs of admirers have to be wondering how long they can keep pulling fat rabbits out of their respective hats. As their ability to conjure up more profits by the usual means—cost-cutting, productivity gains and strong foreign demand—wanes, the answer to that question lies increasingly with that final factor: troubled foreign economies beyond the control of hopeful Canadians.
In the not-too-distant past, the only foreign market whose shifts, swerves and stumbles really mattered to Canadian executives and investors alike was the giant one to the south. Every American sneeze or hiccup could turn into a hospital admission north of the border. The uncertain economic fortunes of the United States remain important, particularly for the Canadian banks that have been aggressively expanding their American footprint. But these days, China and other markets have become critical components of corporate Canada’s good-news story and a key reason profits exceeded expectations even when domestic economic growth didn’t. So when China’s prospects begin to dim, Spain’s banking woes worsen and Latin American governments turn more protectionist, it merely underscores the global threats that could derail the Canadian express. “At this particular stage, there is probably more in the way of downside risks than upside risks to the outlook for earnings and the economy,” says David Rosenberg, chief economist at Gluskin Sheff + Associates.
Those risks start in Europe, where austerity-first policy-makers have failed miserably in their efforts to contain a confidence-crushing banking and fiscal crisis that threatens to blow up the monetary union and unleash havoc on a global financial system still recuperating from the Great Crash of 2008-09. “No solution in Europe means lower commodity prices, which affects roughly half of the earnings in the TSX,” says David Prince, the principal of Harbinger Capital Markets Research.
A battered Europe means more trouble for China, whose economy was cooling anyway, and with it demand for the resources that have underpinned a Canadian economy that is still not fully engaged. Indeed, it already appears that 2012 will see shrinking profits and a less happy ending for both the resource and banking sectors. Unless, that is, China returns to its strong growth trajectory, the Europeans get their house in order, and Canadians continue their recent American-style habit of borrowing up to their eyeballs. All are possible, but none is likely.
Still, the banking-resource duopoly has worked to Canada’s singular advantage, particularly since the 2008-09 collapse, which rained misery on much of the developed world and pummelled financial heavyweights in the U.S. and Europe. Fearing they would be next, surplus-rich China and a handful of other big emerging countries shifted into aggressive stimulus mode, driving up infrastructure and consumer spending, slashing loan costs, stoking price inflation and juicing profits for all manner of commodity suppliers. The result was booming demand for the stuff Canadians dig up or pump out (with the notable exception of natural gas), and new opportunities for the banks. As Arthur Heinmaa, managing partner with Toron Investment Management in Toronto, puts it: “The great boon to Canada’s economic fortunes is that they’ve been focused on two areas, and both have been big winners.” Listed energy and mining firms saw earnings climb 17.7% in 2011 to just under $31 billion, while the banks jumped 16% to $24.6 billion on only 7% higher revenue. As a result, the 1,000 public companies in our annual survey managed to post combined profit in an otherwise tepid economy of $105.8 billion. That was up 5.3% from a year earlier, and the best tally since the record $109.9 billion racked up in 2006—the year before the U.S. housing bubble burst spectacularly and a wave of mortgage defaults in the U.S. spread chaos throughout the global financial system. Total earnings for public and private companies rose 15% before taxes, but are expected to climb only 5% or less this year.
The recovery from the worst financial and economic slump since the Great Depression has been long and arduous, not least for insurance companies, traditionally major contributors to Canadian financial sector profits. They didn’t hold up their end in a volatile environment last year, as earnings for the interest-rate-sensitive group plunged 56%. Sun Life Financial slipped all the way to 985th on our list from 16th the year before. Other prominent members of the Biggest Losers’ club include: Air Canada (it’s never good to be the high-cost player in a competitive marketplace), which plummeted to 991 from 147; Thomson Reuters Corp. (internal organizational headaches didn’t make it easier to peddle expensive desktop products to cost-shedding financial customers), whose vertiginous drop took it to 998th from 36th; and Kinross Gold (project delays, soaring costs), which fell down to 999th from 39th. Last-place honours belong to Yellow Media, which ranked 83rd the previous year. Its walking fingers have been trampled by the Internet ad elephants, but perhaps the Yellow folks can derive faint hope from the experience of some previous cellar-dwellers suffering from PDS—profit disappearance syndrome. Bell Aliant, the biggest loser in 2010, climbed back to profitability and 76th place. Barrick Gold finished dead last in 2009, but cracked the top 10 the next year after ditching a hedging program, and climbed two notches to fourth place in 2011.
While the bottom-dwellers struggle to regain their footing, Canada’s banks continue to churn out heady profits after managing to avoid the financial cyclones that cut a swath through the U.S. and Europe. Their much-envied strength has enabled the Canadians to capitalize on opportunities to expand highly profitable businesses in foreign markets, such as wealth management, and to snatch up valuable assets, including the two-legged variety, from faltering competitors. Last year, they proved beyond a doubt that rock-bottom interest rates, a shaky economy and darkening skies are no impediment to solid banking gains—as long as Canadian borrowers are willing to do their part to fuel credit excesses. As they did the previous year, the Big Five banks all placed in the top 10, although there was a notable shuffle at the top. Toronto-Dominion Bank and Bank of Nova Scotia, with their effective consumer marketing blitzes, vaulted ahead of Royal Bank of Canada, the traditional industry leader, while Bank of Montreal and Canadian Imperial Bank of Commerce retained their seventh and eighth slots, respectively. Energy and mining companies claimed the other five spots in the top 10. Joining No. 4 Barrick was Suncor Energy, which slipped a rung to No. 5, and Imperial Oil, which jumped to sixth from 10th. Potash Corp. moved up to ninth from 12th on the strength of foreign demand. Teck Resources rode the same commodity wave to 10th from 13th. Heading in the other direction was BCE, which slid from ninth to 13th, but remains the second most profitable company in Canada that isn’t directly involved in banking, digging or drilling. Canadian National Railway was 12th, down from 11th the year before. For those trainspotters keeping score, Canadian Pacific Railway finished 46th under the outgoing management, down two notches. And embattled former tech darling Research In Motion slid to 29th from its former lofty rank at No. 5.
While RIM searches for ways to regain its lost lustre and win back skeptical investors, the banks have to figure out what to do now that their gravy train is running out of steam. Consumer loan expansion is slowing, perhaps a sign that the nagging of Bank of Canada Governor Mark Carney about household debt management is finally having an impact. The outlook for Canadian profits generally is “mildly positive over the next 12 months, assuming that the global economy stays on a moderate growth path,” says Peter Perkins, global strategist with MRB Partners in Montreal. “In this scenario, the financials plod along and do okay, but definitely the best is behind them.” Rosenberg adds that “it is a little difficult to ascertain in the next several quarters exactly how the banks are going to derive their profit growth.”
But if financial companies have peaked, what about a resource sector whose fortunes have come to be closely linked with those of a bunch of Communist policy bigwigs? China’s leaders are plainly worried about slower growth that is draining demand for raw materials, equipment and even consumer goods (Mercedes dealers have been offering big discounts). But the party bosses also welcome the inflation-cooling effects and remain reluctant to launch another big stimulus program, even though they have the fiscal manoeuvring room to spread plenty of renminbi around. In one example of what can happen to resource suppliers when the world’s second-largest economy eases up on the gas pedal even slightly, Chinese customers cancelled a raft of contracts in May for iron ore and thermal coal. Analysts speculate that this was either a response to high inventories and weaker steel demand or a ploy to take advantage of falling world prices. Either way, the producers lose. If Beijing fails to engineer a soft landing—which by Chinese standards would mean annual growth holding comfortably above 7%—the slowdown could turn into a rout.
But how to quantify the potential damage? “The sensitivity of commodity prices to Chinese economic activity is very difficult to discern,” Perkins says. “Because China went on such a binge from 2001 into 2011, it’s hard to say how sensitive prices will be in a slower-growth environment.” Some analysts remain convinced the Chinese leaders are so afraid of unleashing unrest that they will pull out all the stops to keep the economy moving fast enough to preserve existing jobs and add more. “If you are looking for a possible light at the end of the tunnel as far as
Canada is concerned—especially when you consider our relative underperformance to the U.S.—you want to look for signs of a flicker in the Chinese economy,” Rosenberg says. “And I think the sooner that they ease policy dramatically—and they do have the latitude—the more we can see the clouds part.” Société Générale’s permabear strategist Albert Edwards, however, predicts the Chinese will not be able to prevent their version of a crash—with growth falling to 5% or 6%. That doesn’t sound too bad, unless you’re a commodity producer. “Canada might be a lightly done muffin, but Australia will be absolutely toast,” Edwards says of a country whose economy has been largely reduced to one trick.
Canadian oil producers would certainly feel the pain. China has been the world’s leading source of new global demand in recent years, accounting for fully half of the growth in the market—and lately likely more than that, given a dramatic drop in India and a handful of other emerging economies. Now that Chinese industry is shifting to a lower gear, forecasts call for less than a million barrels a day being added to current global consumption of about 89 million. That would be less new demand than at any time in the past dozen years, apart from the depths of the global recession in 2009. Demand in the industrial world has already fallen to the 2009 lows and is expected to shrink further, as U.S. consumption declines and Europe’s economy does an austerity-driven double-dip off the three-metre board. “What happens in Europe really has no bearing on oil consumption growth, because they are a stagnant economy,” says Peter Tertzakian, chief energy economist at ARC Financial Corp. in Calgary. “But if this sizable chunk of the global economy stops spending on Chinese goods, then China slows and demand for oil follows.” All in all, it’s not a pretty picture, suggesting it may be time to find a third act for the Canadian economy before a disappointed investment crowd heads for the exits.
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