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Third-quarter earnings season forecast: Overcast, chance of pain

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The fall earnings season can be a dampening one.

Early projections, full of promise, begin to yield to the market's inclemency by the second half of the year. "Everybody starts off way more optimistic, then reality starts to set in almost every year. That's just a given," said John Zechner, chairman of J. Zechner Associates.

With third-quarter results due over the coming weeks, growth expectations are waning for the corporate sector. Negative guidance from S&P 500 companies is outpacing good news by a factor of 2.9, according to S&P Capital IQ. Other estimates put the ratio of negative-to-positive pre-announcements as high as 6.1.

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The same trend is afoot in the Canada. "Back when people were popping New Year's champagne, they were looking for strong double-digit gains in the back half of the year," said Peter Buchanan, senior economist at CIBC World Markets. "We're clearly not going to see that." For all of 2013, he's forecasting something closer to a 2.5-per-cent increase in earnings among companies on the S&P/TSX Composite Index, compared with the 10-per-cent estimate that prevailed late last year.

Few financial minds will be consumed by earnings announcements, however, if U.S. politicians continue to bicker over fiscal issues. Should a government shutdown bleed into earnings season, fourth-quarter guidance could take precedence over actual results.

Since the recession, strong corporate earnings growth has been crucial to stock market returns. Particularly in the United States, the corporate sector has shone through a tenuous recovery mired in weak domestic economic fundamentals and macroeconomic shocks.

The fear is that profit margins have no more room to climb. "U.S. margins are at an all-time high and that's a little scary," Mr. Zechner said. "If you can't get any more margin growth, how do you get the earnings expansion?"

In the years since the recession, a number of economic forces have combined to enhance profitability in the United States. A weak U.S. dollar has improved export competitiveness, lack of inflation has kept input costs low and emerging market strength has maintained demand.

And record-low interest rates have minimized financing costs. "That, I think, is coming to a bit of an end," Mr. Zechner said. But the fiscal improvements to Corporate America are not owed to cyclical factors alone, he said. "I think there is a long-term upwards trend. I think companies are more profitable than they used to be. They use capital more efficiently."

This economic recovery has been unusual in that it has not been led by the consumer. "This time around, it was more of a policy-led expansion," said Pierre Lapointe, head of global strategy and research at Pavilion Global Markets Ltd. Now, with the U.S. Federal Reserve inching toward slowing its bond-buying program, the U.S. economy will wean itself from fiscal and monetary stimulus, Mr. Lapointe said. "We expect in 2014, the U.S. consumer will start to lead again, and we'll get the second phase of this expansion." He, too, sees the possibility for further improvements in margins.

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For the U.S. third quarter specifically, earnings misses will be driven by "a pickup in interest rates during the second half of the quarter, a resulting strengthening in the value of the U.S. dollar, an increase in oil prices following the flare-up of tensions with Syria, as well as weaker-than-expected [second-quarter] GDP," S&P Capital said in its report.

The financial and energy sectors are expected to be the worst performing, while industrial stocks are picking up as the outlook improves in Europe, Japan and China.

If the worst-case scenario imagined for emerging markets doesn't unfold, Canadian corporations could benefit disproportionately, Mr. Buchanan said. "Our stock market is much more levered to global growth, and particularly emerging market growth, than the U.S. is."

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About the Author
Investing reporter

Tim Shufelt joined the Globe and Mail in August, 2013, primarily to cover investments for Report on Business. Prior to the Globe, he worked as a staff writer at Canadian Business magazine, a business reporter at the Financial Post, and covered city news and courts for the Ottawa Citizen. More


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