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Corporate profit margins still well below pre-crisis peak

Corporate profit margins in Canada aren't as close to their historic peaks as their U.S. counterparts are - but whether they still have much room to grow and drive stock prices higher will depend on commodity prices and interest rates.

Data gathered by National Bank Financial show S&P/TSX composite index profit margins stand at 15.7 per cent - up from less than 10 per cent in early 2009, yet still well below their precrisis peak of more than 19 per cent.

That's considerably more sedate than the wild roller coaster in profit margins that U.S. stocks have experienced over the past four years. After having swung from a peak of about 18.5 per cent in mid-2007 to just 7 per cent in early 2009, S&P 500 margins have surged to about 15.5 per cent. Outside of the supercharged markets of 2006-2007, that's within one percentage point of their historical peaks.

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When measured against the overall economy, profit margins also look more stretched in the United States than in Canada. Total pretax corporate profits in both countries, as a percentage of gross domestic product, are running almost dead even - 11.3 per cent in the U.S. and 11.2 per cent in Canada. But while the peak in the previous cycle in the U.S. was just over 12 per cent, the Canadian peak was nearly 15 per cent.

"This leads me to conclude that there is more upside for profit margin expansion in Canada than in the U.S.," said Pierre Lapointe, global macro strategist at Brockhouse Cooper in Montreal.

The Commodity Effect

Indeed, a key factor in the growing concern about U.S. profit margins - namely, the alarming surge in energy and other commodity costs - is considered a boon to margins on Canada's commodity-heavy S&P/TSX composite, fully half of which is made up of resource stocks.

As a result of the commodity effect, expectations for the Canadian and U.S. markets have diverged. Research by National Bank for an upcoming report found that equity analysts' consensus forecast is for S&P 500 margins to increase by a slim one percentage point this year, while Canadian margins are forecast to expand by three percentage points.

However, there's no assurance that the Canadian stock market can repeat the profit margin levels it achieved in the last cycle. Strategists said record high prices for commodities in 2008 - highlighted by oil's dramatic surge to nearly $150 (U.S.) a barrel - were the key driver behind the record margins seen in Canada at the time, and the main reason why Canadian margins peaked higher than those of the United States in the last cycle.

"Unless we can get back to $150 oil, we might have some trouble [reaching those peak margin levels]" said Peter Buchanan, senior economist at CIBC World Markets.

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The Interest Rate Effect

Strategists note that profit margins in both countries have generally been trending higher from cycle to cycle over the past two decades - a pattern that can be traced to the success that policy makers in Canada and elsewhere have had in taming inflation. The result has been a steady decline in interest rates that has significantly lowered costs for businesses - a cheap-money advantage that was particularly apparent at the peak of the last cycle.

But with interest rates already at historic lows, the interest-rate effect on margin improvement may have run its course, National Bank Financial economist Marco Lettieri said. "You might have reached the peak of the uptrend." he said.

Vincent Delisle, strategist at Scotia Capital in Montreal, noted that "the sequential pace of margin expansion" from one quarter to the next has been slowing - typically a sign that margins are approaching their peak. However, he believes that because Canada's margin decline and recovery were less dramatic than that in the U.S., Canadian margins should continue to expand for longer than U.S. margins.

"Canada lags the U.S.," he said. "We didn't see nearly the blowout in profit margins as the S&P 500 [did]"

National Bank Financial points to a couple of trends that suggest profit margins on both sides of the border haven't peaked yet.

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First, producer prices - the prices that goods producers charge their customers - are still rising faster than labour costs. Typically, the bank said, this gap must close before profit margins begin to contract. Second, Canadian and U.S. capacity utilization remains well below its cyclical highs, which again has historically implied that margins still have room to grow.

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About the Author
Economics Reporter

David Parkinson has been covering business and financial markets since 1990, and has been with The Globe and Mail since 2000. A Calgary native, he received a Southam Fellowship from the University of Toronto in 1999-2000, studying international political economics. More

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