CIBC World Markets has downgraded its Canadian earnings outlook for the first half of 2004, due to its forecast that the Canadian dollar will soon trade in the 78¢-80¢ range.

In its November Canadian Portfolio Strategy Outlook, CIBC says that most of the dollar-induced damage to earnings should occur in the materials and industrial sectors, both of which merit significant underweighting.

The firm says that an 80¢ dollar is a material threat to earnings on three different fronts: labour costs, margins and the knock-on effects of layoffs on consumer spending and domestic demand.

CIBC says that the last time Canada-U.S. exchange rates were so close manufacturing earnings collapsed and production fell at double-digit rates. For resource producers, the roughly 25% appreciation in the loonie “will deal a body blow to Canadian dollar margins. That effect, in itself, will knock some 13% off TSX operating earnings and when coupled with the impact on cost competitiveness, could potentially decimate earnings in the industrials and materials sectors.”

CIBC estimates that if the economy is forced to operate with a near-80¢ exchange rate without the Bank of Canada easing interest rates, GDP growth next year would be shaved by some 2%-3% on a full annual basis.

CIBC is cutting earnings estimates for the materials and industrials sectors by as much as 40%.

Energy, financial and telecom shares will be as good as any place to wait out the impact of an 80¢ dollar, says CIBC

It suggests better-than-expected prices for both oil and natural gas will more than offset negative exchange effects on energy earnings while earnings in the financials and telecommunications are relatively insulated from a higher Canadian dollar. “In fact, in the case of telecoms, a higher loonie actually helps the bottom line by reducing the cost of imported capital inputs.”

As for the financial sector, CIBC is maintaining a market weight on banks, insurers and REITs. “Canadian banks will likely continue the trend of significant capital generation and dividend increases in Q4,” it says.

It expects Canadian life insurers translate higher equity markets to translate into higher fee income and higher variable annuity sales.

“The life insurance industry is beginning to show signs of recovery with the recovery of the equity markets. In Canada, the last of the big mergers has probably taken place and we are not likely to have a change in federal government policy on cross-pillar mergers (combinations of banks and insurers) any time soon. Spreads on Canadian life insurers are therefore likely to remain largely driven by the health of the equity markets and credit strength until then.”

The firm also notes that its technical strategist believes that equity markets will be higher next year with the S&P 500 hitting 1,175 and the S&P/TSX composite index hitting 8,500, both about 10% higher than current levels.


CIBC says bonds will benefit as the Bank of Canada cuts interest rates as the Bank of Canada acts to rein in the soaring loonie. “Falling rates throughout the yield curve will set the stage for strong positive total returns from the bond market over at least the next two quarters, in contrast to expected negative returns from the TSX.”