October 14, 2012 / 2:47 PM / 5 years ago

Bay Street: Weak commodities set to punish company profits

A Bay Street sign is seen at the financial district in Toronto, October 10, 2008.Mark Blinch (CANADA)

TORONTO (Reuters) - Canada's biggest companies may join their Wall Street peers in posting poor financial results for the latest quarter as miners and energy producers struggle with soft global demand and volatile commodity prices.

Energy and materials shares make up about half of the value of the Toronto Stock Exchange's benchmark S&P/TSX composite index .GSPTSE and include such blue chips as Cenovus Energy (CVE.TO), Teck Resources Ltd TCKb.TO and Goldcorp Inc G.TO. All three are expected to report a year-on-year drop in third-quarter earnings per share in the coming weeks.

Overall, companies in the blue-chip S&P/TSX 60 index .TSE60 are expected to report an earnings decline of 0.4 percent from a year earlier, according to Thomson Reuters StarMine SmartEstimates.

And if warnings from U.S. resource giants Alcoa (AA.N) and Chevron (CVX.N) last week are any indication, there's also a high risk that Canadian companies could issue disappointing outlooks that could hit their stock prices.

"We have had strong earnings for the last two to three years for S&P and TSX," said Craig Fehr, Canadian market strategist at Edward Jones in St. Louis. "Those trends have powered equities higher during that time but we're now running up against the situation where the economic environment on a global scale has softened.

"Corporations are struggling a little bit more now to deliver that profit growth because much of the cost savings that they were extracting over the past couple years have been realized."

TSX LAGGING S&P 500

With the global economy sputtering because of Europe's debt crisis and a slowdown in Asia, it's no surprise that growth-sensitive sectors such as energy and materials have been among the worst-performing sectors this year.

This has caused a dramatic gap between Toronto's S&P/TSX composite and the much more diversified S&P 500 index. The TSX is up 2 percent in 2012, while the S&P has gained 14 percent.

Fehr noted that while commodity prices have been volatile day to day, the broader trend has been one of weakness. This is especially true in the energy space, which is expected to show an earnings decline of 15 percent, according to Thomson Reuters data.

Because of limited ability to move Canadian crude oil abroad, local producers are saddled with a discount to international prices, especially for heavier grades. And natural gas prices remained weak throughout the third quarter.

Even when oil prices spike, it doesn't necessarily translate into higher profits.

"It's more supply concerns versus actual demand for oil - so for example unrest in the Middle East - that's what's pushing oil prices up," said Kien Lim, associate equity strategist at RBC Capital Markets. "It's probably less impactful for the bottom line."

MATERIALS DRAG, FINANCIALS RESILIENT

The TSX index's materials sector, home to miners of industrial and precious metals and potash, looks in much worse shape than the overall index, with profits expected to fall 19 percent.

Commodity prices are not entirely to blame. The price of spot gold, which traded around $1,762.20 an ounce on Friday, is up from a year earlier. Yet shares of Canadian precious metal miners have fallen 7 percent this year.

"Gold stocks have not performed anywhere near to the same extent as bullion because the costs of getting it out of the ground have gone up a lot higher than gold has," said Gavin Graham, president of Graham Investment Strategy.

Much of the good news for the TSX this quarter is likely to come from financial companies, which make up about a third of the composite index.

Canada's stable dividend-paying banks, which don't start reporting results until November, have performed relatively well since the 2008-09 global recession.

By comparison, insurers such as Manulife Financial Corp (MFC.TO) and Sun Life Financial Inc (SLF.TO) have taken a beating as historically low bond yields and languishing stock markets have hammered their profits.

But when compared with their dismal results last year, the insurers are set to show impressive earnings growth. As a result, earnings in the financial sector are expected to rise nearly 70 percent.

"The denominator is relatively small, so that's why the comparisons look so great," said Pat McHugh, Canadian equity strategist at Manulife Asset Management.

VOLATILITY SWINGS BOTH WAYS

Even with mediocre earnings expectations - 1.4 percent growth for the TSX in 2012 overall - Canada's market is still expected to grind higher in the final quarter.

A Reuters poll published last month forecast a rise by the TSX to 12,800 by the end of the year - it was at 12,202.04 on Friday - buoyed by a central bank stimulus-inspired rally. That rally has pushed global equities up around 15 percent since early June, but it has stalled recently. <EPOLL/CA>

"We've got the upcoming U.S. election, the U.S. fiscal cliff, the situation in Europe that continues to drag on and a slow-going Canadian economy," Fehr said. "All that boils together to, in our view, create probably a lift in volatility as we progress through the balance of the year.

"But volatility doesn't have to mean just market declines, volatility is a door that swings both ways."

Editing by Jeffrey Hodgson, Frank McGurty, and Peter Galloway

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