The Canadian finan-cial services industry has been battered mercilessly in the past year, and the immediate future doesn’t look a whole lot better. While much of the stock-price pain may already have been inflicted, the timing of an earnings recovery remains decidedly uncertain.

The big banks will begin reporting their earnings for the third quarter ended July 31 after Investment Executive goes to press. But if recent earnings announcements by other financial services firms are any indication, the industry behemoths won’t have much good news.

In Sprott Inc.’ s first quarterly earnings conference call as a public company, founder and CEO Eric Sprott observed that the financial system is undergoing a “systemic financial meltdown.”

Shortly after that, Toronto-based GMP Capital Trust reported profits for the second quarter ended June 30 were $15.7 million, down by 59% from the same period last year, and the firm, an income trust, was also forced to cut its distribution as a result.

Similarly, Vancouver-based Canaccord Capital Inc. reported that its profit for the its first quarter ended June 30 was $16.5 million, down by 58%. Canaccord president and CEO Paul Reynolds sounded a gloomy note when announcing the results, saying that he expects “the business environment to remain challenging for the balance of the calendar year.” Reynolds pledged to focus the firm on enhancing shareholder value by cutting expenses and finding ways to unlock the value in its businesses.

Next up was CI Financial In-come Fund of Toronto, which also saw its quarterly profit decline, albeit by only 11% to $135.8 million. CI president and CEO Bill Holland called the prevailing market conditions “very, very difficult” for small and mid-sized brokerage firms, adding that the market environment was “about as bad as you could imagine” in the second quarter.

Holland moved to squash talk that CI may sell its brokerage subsidiary, Blackmont Capital Inc., but he did say that the dealer had reduced its capital-markets group by about a third in an effort to take a more focused approach in that business. Holland later disclosed that CI has been shopping for strategic alliances over the past months.

That’s the market climate facing the financial services industry right now. So far, the two biggest sources of pain for firms have been writedowns inflicted on companies with direct exposure to troubled, liquidity-starved assets such as asset-backed commercial paper and collateralized debt obligations; and, second, plunging volumes in market-related businesses (an underwriting drought, a decline in M&A activity, and even a slowdown in wealth management).

The writedowns are inherently unpredictable because they are driven by the spread of market worries to different asset classes. While it appears that most of the big writedowns might be in the past, few market-watchers are willing to declare that the worst is over. Some see the contagion continuing for some time, possibly through next year and beyond. As the credit crunch drags on, both the prospect of further writedowns and a gloomy outlook for market-related revenue will continue to weigh on the performances of financial services companies.

“We believe that the credit crisis is far from over, and is beginning to rear its ugly head in other parts of the world,” notes Desjardins Securities Inc. analyst Michael Goldberg in a recent report. “As long as uncertainty remains, bank stock performance will not improve in the long term.”

This underlying market uncertainty isn’t expected to dissipate anytime soon. According to Stephen Roach, former chief economist at Morgan Stanley and now chairman of Morgan Stanley Asia, the crisis is far from over: “The main reason is that the bubbles that have burst — property and credit — became so big they ended up infecting the real side of the U.S. economy. And as the U.S. adjusts to much tougher post-bubble realities, the rest of an interdependent, globalized world should follow.

“Moreover, there are undoubtedly feedback effects between the various stages — especially as the business cycle now starts to bear down on financial institutions that were initially buffeted by the credit contagion. A new round of earnings pressures on banks and other lending institutions could exacerbate the credit crunch further, reinforcing the cyclical pressures on debt-dependent economies in the U.S. and around the world.”

Roach predicts that these effects will last well into 2009 and possibly spill over into 2010.

@page_break@Analysts at New York-based Merrill Lynch & Co. Inc. are also expecting the crisis to last for some time. “We continue to believe that investors are significantly underestimating both the scope and the depth of the credit bubble and its subsequent deflation,” states a recent report by Merrill Lynch chief investment strategist Richard Bernstein. “The problems are certainly not limited to large U.S. institutions that are overexposed to ‘U.S. subprime’. The effects are global and far-reaching.”

As a result, the Merrill Lynch report suggests that the global financial services sector is facing “a massive consolidation.” It points out that the financial services industry has created excess capacity, and now that the credit boom is over, it must face contraction and consolidation. “Because of many factors (including government policies and continued excess liquidity),” the report says, “there has been very little consolidation in the global financial sector even though many financial institutions are confronting serious problems.”

Some of the Canadian banks could be considered possible buyers in a global consolidation. A couple of them have weathered the credit crisis reasonably well, putting them in a position to buy. And as they face growth constraints in the domestic market, they have good reason to buy — if they can find the right opportunity. Any major foreign acquisition, however, would be a bold gamble amid such uncertain markets and weaker short-term earnings prospects.

Analysts have been trimming their estimates for Canadian bank earnings. According to a report from Genuity Capital Markets analyst Mario Mendonca, bank earnings estimates have been lowered by about 7% so far this year and are down by 12% since late 2007. And he sees room for them to go even lower.

Indeed, in the run-up to their latest quarterly announcements, several analysts have reduced their earnings forecasts. In a report, Blackmont analyst Brad Smith cited “negative assessment of both medium-term credit risks and capital-market pressures facing domestic banks over the next 12 to 18 months” to explain the report’s earnings and price target reductions.

Analysts are expecting the banks to report an average earnings decline of about 10% for their fiscal third quarter vs the same period a year ago. “Domestic banking should continue to underpin the results, with volume growth remaining strong. Spreads are forecast to be stable and expenses will remain well controlled,” notes Bank of Montreal capital markets analyst Ian de Verteuil in a report. But, on the downside, the banks face weakness in their capital markets businesses and deteriorating credit conditions due to rising loan losses.

BMO’s report predicts that provisions for loan losses for the Canadian banks will be, on average, 70% higher than a year ago and that they will have doubled for three of the big banks. That said, the report notes that loan losses are still below 2002 levels, which was the last major downturn in the credit cycle.

This latest downturn may have a way to go yet, however, the Blackmont report suggests: “The prevailing credit cycle remains in the very early stages of a cyclical deterioration. As a result, we expect further confirmation of a gradual deterioration in domestic credit and more pronounced deterioration in the U.S. loan portfolios.”

This comes at a time when, with capital markets-related businesses struggling, the core banking business is that much more important. According to a report from UBS Securities Canada Inc., market-sensitive revenue now accounts for less than 16% of overall bank revenue. The upside to this is that while the outlook for these segments may not be great, the UBS report says, they represent a less significant risk to bank earnings.

The flip side of that coin is that the banks now have a greater dependence on the performance of their bread-and-butter banking business. “In our opinion, with declines in capital-markets businesses and rising risk in U.S. platforms, the importance of the Canadian retail business has risen,” notes National Bank Financial Ltd. analyst Robert Sedran in a report. “In other words, if domestic personal and commercial banking drop the baton, there does not appear to be any other segment in a position to pick it up.”

Despite the risk associated with a less diversified business mix, the NBF report suggests that there are reasons to believe that the banks will weather this credit downturn better than they have previous cycles. For one, the banks have all increased their focus on retail lending, which normally has lower, more predictable loss rates. Also, the report argues, risk management has improved and the Canadian mortgage market is in fundamentally better shape than the U.S. market.

“We continue to believe that the long-term impact of the liquidity crisis will be more positive for the Canadian banks,” states the NBF report. “As the funding pressure fades, loans are likely to be underwritten with more favourable pricing, given that corporate credit spreads have widened.”

While the current quarter is expected to be another tough one, analysts are looking forward to future earnings and stock price recovery. Indeed, Genuity’s Mendonca notes that once banks rebuild their returns on equity to sustainable levels, their stocks should trade at higher levels. If that happens, he notes in his report: “We can see more than 30%-35% upside in the banks over the next 18 to 24 months.”

To get to that point, the banks may still face some choppy waters. Not only is there acute uncertainty as to the future of both financial markets and the global economy, there’s also the threat of regulatory action in response to the credit crisis that could limit banks’ flexibility by forcing them to hold more capital on their balance sheets in support of certain assets.

One item that analysts will be watching in the upcoming reporting season is what the banks do with their dividends. The Blackmont report indicates that four of the Big Six banks are due to raise their dividends. The report warns: “Failure to raise dividends would signal continued lack of visibility with respect to earnings growth and future capital requirements.”

While the banks can fall back on their lending businesses to get them through the credit crisis, securities firms and asset managers that are completely dependent on capital markets appear to be in a tougher position. Even brokerage firms that have apparently sailed through the credit crisis with no big writedowns to confess can’t escape the spectre of declining business volumes.

A report from New York-based Oppenheimer & Co. Inc. recently slashed earnings estimates for venerable Wall Street firm Goldman Sachs Group Inc. , noting: “Customer volumes, overall weak global equity markets and weak advisory and underwriting revenues” are undermining its earnings power.

In Canada, where most of the independent brokerage firms are small or mid-sized, the best they can do is batten down the hatches and hope to ride out the weak markets. Firms may be able to control their own costs, but a resurgence in investor confidence and a reduction in market uncertainty is far beyond their control.

One positive for asset-management firms is that while long-term fund sales have been shaky, the decline in long-term mutual fund assets is being largely offset by a sharp jump in short-term assets (up almost 50% since the crunch began). In fact, short-term funds outsold long-term funds in every month since last October.

Clients are apparently parking their cash in money-market funds. It may well be that fund firms can eventually convert these short-term assets into long-term assets when market conditions improve.

While that remains to be seen, as does which firms win that business, on the bright side, the sharp jump in short-term fund assets and strong sales suggest that investors still have faith in the industry. Investors may have been spooked by the discovery of troubled ABCP in certain money-market funds when that market seized up, but fund firms’ decision to buy back that paper appears to have soothed investors and instilled confidence that fund firms will stand behind their products.

That may be one small sign of investor confidence, but many more will be needed before the industry can hope to see a return to its glory days. IE