Earnings season on track for double-digit profit gains

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Canadian investors will be looking for a strong showing this earnings season to give a boost to domestic equities, which have been falling further and further behind the red-hot U.S. stock market.

The quarterly deluge of financial statements in both countries is just getting under way, and double-digit profit increases are expected to add support to rising equity prices.

But improving profitability in Canada is likely to be offset by caution surrounding the fraught NAFTA negotiations, and the potential consequences for the domestic economy.

"It's one of those great unknowns," said Ryan Bushell, president and portfolio manager of Toronto-based Newhaven Asset Management Inc. "You're going to see people, especially those with cross-border business, be pretty darn cautious."

The raw numbers, however, look pretty good. Fourth-quarter earnings for S&P/TSX composite index companies are expected to climb 14.1 per cent over last year, according to data provided by Thomson Reuters.

That compares with 12.4-per-cent growth in S&P 500 index earnings.

Additionally, while growth in previous quarters has been inflated by huge gains posted by Canadian energy companies emerging from the oil crash, the easy-comparisons effect has mostly worn off by this point. Even after excluding the oil and gas sector, Canadian earnings per share are still tracking toward an 11.4-per-cent increase over the same quarter in 2016.

Of course, what matters in earnings season is not just how well a company has performed, but how well it matches up to forecasts.

That creates an incentive for managers to reduce expectations in advance of earnings season, making for a lower bar to clear and thus avoiding the wrath of disappointed shareholders. So the market as a whole typically beats the Street's estimates by a narrow margin.

It's still very early days in the Canadian earnings season, with just eight companies in the S&P/TSX composite index having reported. But so far, so good, with those companies collectively beating forecasts by 2.1 per cent.

Cannabis producer Aphria Inc. beat the Street, with EPS of $0.05 easily exceeding estimates of $0.01, alongside year-over-year revenue growth of 63 per cent. But that wasn't enough to spare the stock from a broad sell-off in marijuana names, which took share prices down by as much as 30 per cent over the next two days. Most of those losses were quickly offset, as the volatile sector rallied fiercely.

As always, the big sectors to watch this earnings season are financials and energy, which together account for about 55 per cent of the market capitalization of the main Canadian index.

According to Thomson Reuters figures, Canadian financials are on track for a jump in fourth-quarter earnings of 17 per cent.

Meeting or beating that estimate should put Canadian banks in good stead considering current valuations. "We think valuations are still reasonable," wrote Robert Sedran, an analyst at CIBC World Markets Inc. "In fact, they trade at a lower multiple than they did this time last year despite a brighter economic outlook."

Meanwhile, the oil-and gas sector's results should continue to demonstrate the upside of what has been a "meaningful restructuring, with profitability significantly improved from several years ago despite the persistently low energy price environment," Brian Belski, chief investment strategist at BMO Nesbitt Burns, said in a note.

The latest headwind blowing against Canadian oil producers has been a widening of the price gap between U.S. and Canadian crude. A shortage of pipeline capacity has resulted in the steepest discount on Canadian oil in four years.

As a result, Canadian energy stocks have mostly sat out what has been a six-month rally in the global crude oil market.

But that kind of heavy discounting of domestic oil tends to be short-lived, after which Canadian oil and gas stocks may be in good shape to make up some lost ground, Mr. Belski said.

Looming over this earnings season, however, and likely the topic of much management commentary, is the potential for the termination of North American free-trade agreement, which U.S. President Donald Trump has suggested is a strong possibility. Mr. Trump threw his latest curveball on Thursday, when he suggested on Twitter that the trade talks should also be the forum to deal with a border wall with Mexico.

"The earnings implications in the event this continental pact is disbanded are unknown," Kevin Chiang, a CIBC analyst covering the industrials sector, said in a note.

Mr. Chiang noted that several British transportation stocks dropped by more than 10 per cent in the immediate aftermath of the Brexit vote in June, 2016. Canadian companies tied to North American trade could take a similar hit should NAFTA be torn up, he said.

Few analysts, however, think that is the most likely outcome.

"While Canada is not without its issues, we believe Canadian equities will likely see renewed inflows in 2018 as strong U.S. earnings are positive for U.S. growth and thus positive for Canadian equities," Mr. Belski wrote.