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What We'll See in Q3: Lowering Earnings Expectations

Now that the second quarter books have been closed, the corporate earnings parade will soon start, bringing with it an assortment of cheers and boos. The Q1 season was pretty decent for the U.S., as roughly seven per cent of the S&P 500 reporting companies came in above street consensus (the strongest performances were in materials and financials).

Here at home, it was a different story as just over one per cent of the TSX companies missed on the downside, with weakness in energy and materials.

This particular quarter could prove to be a little more challenging for investors as compared to the strength of the first quarter for a few reasons. First and foremost, there is the slippage in global economic growth in the wake of the Japanese earthquake and nuclear accident. In addition, we have witnessed a deterioration in sentiment and spending due to higher energy prices going into the quarter. We have talked about the macro implications for weeks now, especially in areas like employment and capital goods spending, which have illustrated how firms have responded to the economic turbulence. Both, of course, are aimed at protecting the bottom line and in the case of this past quarter, and depending on the sector, profit margins could have been squeezed from the revenue and cost lines.

For Canada, we have already seen margin pressure for the banks this year, but this is also showing up in the consumer space. Non-discretionary areas (like grocery stores) have held up okay, but there is less confidence in the energy patch this earnings season following the decline in crude oil prices from early April. To be sure, most of the impact of this retreat won't be felt until the third quarter, given the lag between spot price movements and delivery revenues. But that doesn't mean we won't see any drag and this could be compounded by the fact that the Canadian dollar hit its recent highs near US$1.06 towards the end of April. For those companies that generate the bulk of their earnings in US dollars, repatriating those earnings back at a higher Loonie puts the squeeze on the revenue line, without any compensating declines in C$-based costs (like salaries).

The main focus over the coming weeks, however, will be not so much on what just happened but how companies see things shaping up over the rest of the year. If recent US and Canadian business sentiment indicators are any gauge, the outlook for the second half is not going to be as rosy as views established at the start of the year. Central bank rhetoric has highlighted the temporary impacts of things like Japan and gasoline prices, with expectations of a resumption of stronger economic growth over the next two quarters. For now, most CEOs don't seem to be subscribing to that outlook and are more likely to guide analyst expectations lower in order to prevent major disappointments in performance later.

Should guidance come in well below current market estimates, then the rough ride experienced in North American equities during May and June could be repeated during the summer.

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