The third quarter may go down as the most triumphant earnings decline in corporate history.
With earnings season basically wrapped up – but for the notable exception of Canada’s big banks – total profits are on track for a dip of less than 10 per cent in both Canada and the United States, compared with the same quarter last year.
To limit the earnings hit to single digits in the middle of a brutal second wave of COVID-19 infections amounts to a “remarkable achievement,” CIBC World Markets strategist Ian de Verteuil said in a note.
The recovery of North American earnings is happening far more quickly than the market consensus predicted just a few months ago.
“Equities likely could have already seen the worst of earnings declines. This positions stocks well for 2021,” Mr. de Verteuil said.
Profit margins tell the story of how big business has adapted to the pandemic.
The average profit margin for companies in the S&P/TSX Composite Index has historically been about 10 per cent. In the second quarter, as governments slammed the brakes on the Canadian economy to defend against the first wave of the pandemic, that figure plunged to 6.6 per cent.
In the latest quarter, Canadian profitability snapped back to 9.7 per cent. It’s a similar story in the United States, where S&P 500 margins rose to 11.5 per cent in the third quarter from 8.9 per cent.
“Corporate Canada (and America) has done a great job of taking costs out of the system during the pandemic,” Hugo Ste-Marie, a strategist at Scotia Capital, wrote in a recent report.
“If topline growth resumes in 2021-2022 as we expect, and businesses are able to keep their cost structure roughly unchanged, profitability could heal much faster than expected.”
All else being equal, a substantial upward revision of earnings from existing forecasts is exceptionally bullish for stock prices.
The spike in third-quarter profitability is the result of businesses slashing costs wherever they can, while squeezing more output from fewer workers. (Governments, for their part, have sought to soften the blow of lost wages on households, with pandemic-related transfers generally more than offsetting the reduction in incomes in Canada.)
Also supporting Corporate Canada in the third quarter was the continuation of extraordinary levels of monetary and fiscal stimulus, a rebound in global trade and the lessening of economic and commercial restrictions, as the fight against the coronavirus generally became more targeted.
Nearly every sector of the stock market surprised to the upside, with 70 per cent of S&P/TSX Composite Index companies beating Bay Street forecasts.
Total third-quarter profits are expected to have declined by 9.7 per cent, according to Refinitiv data. Excluding the energy sector, earnings are expected to have dropped by only 1 per cent. If the Big Six banks can manage to beat the Street when they report results this week, the quarter’s final result could look better still.
Back in July, the consensus forecast was for a 30-per-cent drop in third-quarter TSX earnings.
It is a similar story in the United States, with S&P 500 quarterly earnings falling by 6.5 per cent, compared with Street expectations in July of a 25-per-cent decline.
Looking ahead to the coming quarters, corporate earnings should benefit from a couple of notable tailwinds.
The first is the rebound in the manufacturing sector, which has registered at least four straight months of expansion, and which tends to precede a boost to earnings.
Second is the rising hope that vaccines can bring about an end to the pandemic sooner than many thought possible. A return to normal starting as soon as the spring could see a leaner, more productive corporate sector reach peak profit capacity earlier than expected, said Aubrey Hearn, head of equities at Sentry Investment Management.
“It’s still going to be a very tough first half of 2021,” Mr. Hearn said. “But once things normalize after that, the earnings power of a lot of these businesses could be a lot higher than people think.”
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