Canada’s “domestic momentum” should counter some of the drag that a soaring loonie poses to corporate earnings, according to a new report from CIBC World Markets Inc.

“We see profit levels north of the border benefiting from some critical offsetting factors,” says Peter Buchanan, senior economist in the latest TSX Earnings Watch.

“Canadian consumers and businesses still look healthier, based on a range of indicators, including wealth and income growth and credit availability. Retail sales have also held up better north than south of the border. We expect all of that to translate into better top-line momentum, the lack of which stateside has helped spark fears about the sustainability of the corporate earnings recovery.”

These factors should also offset or mitigate the impact of a strong Canadian dollar, Buchanan says. “Note that many of the TSX’s largest listed members have operations or sources outside Canada. Lower non-C$-denominated costs for these firms could soften some of the direct blow from the costlier currency.”

Still, the loonie’s march to parity poses a challenge to profits in several sectors.

“Exposed sectors include not only traditional mainstays such as auto parts, but also industries like communications and electronic equipment and pharmaceuticals, which are highly levered to U.S. or overseas demand,” Buchanan says.

Buchanan says the sectors poised for the greatest year-on-year earnings growth this reporting season include health, gold, and info tech stocks. “Tech earnings readily surpassed the matching S&P 500 group last quarter and the Canadian sector’s greatest leverage to high growth areas points to a repeat of that pattern,” he says. Also, the financial sector should benefit from firmer year-on-year earnings growth by both the banks and insurers.

On the flip-side, Buchanan says, year-over-year declines in the rail and aerospace segments are likely to weigh on the industrial sector, which should still do better than the matching S&P 500 group.

Analysts expect earnings among TSX composite companies to fall 31% year-over-year this quarter, compared to -22% in the U.S.

“The upcoming Q3 earnings reports will provide a critical test of whether equity markets on both sides of the Canada-U.S. border can continue their winning ways,” says Buchanan. “Despite some pre-curtain jitters, the show stateside has opened well enough, with over three quarters of early S&P 500 reporters beating expectations. No less significant given top-line concerns, 60% of those firms topped revenue estimates.”

Looking ahead, consensus forecasts for a 51% year-over-year rise in TSX Q4 earnings “still seem to defy gravity,” says Buchanan. “But thanks to an easy comparison with a weak year-earlier reporting period, that seemingly high peak may not, in fact, prove to be so unconquerable. Earnings dived by 40% in the final quarter of 2008 as commodity prices and domestic spending tanked in the wake of Lehman’s demise.”

As for 2010, Buchanan notes that markets are already trading on fairly generous assumptions about earnings growth but could get a lift from a delayed Bank of Canada retightening cycle.

“The consensus continues to price in at least two Bank of Canada rate hikes by mid-2010. That is very likely too aggressive, given prospects for continued 2% or less core inflation, not to mention the Bank’s own concerns about the currency.”

IE