IATA’s Chief Economist asks whether the current mood of optimism is justified
The annual meeting of G20 finance ministers and central banks earlier this month produced considerable optimism about the breadth and strength of the current economic upturn.
We also saw this surge in confidence in our July survey of airline CFOs, where expectations of future airlines’ profitability rose back to post-Global Financial Crisis highs.
Economics is of course known as the ‘dismal science’ and while I don’t want to pour cold water on the current buoyant mood in the industry, I do want to draw attention to the risks ahead.
Central bankers in advanced economies are starting to reverse super-supportive monetary policies
Let me start with the good news. The current economic upturn is certainly strong and increasingly widespread.
Most measures of confidence amongst businesses and consumers are back to where they were in 2014 and consistent with the global economy growing at a solid rate of 2.5%.
Central bankers in advanced economies are starting to reverse the super-supportive monetary policies of the past eight years, slowly raising interest rates and cutting back on financial asset purchases (known as QE). The consensus view is that the economy is strong enough to absorb such tightening.
Fuel prices have spiked higher, but the expectation is that newly-competitive US tight oil producers will increase supply and cap any further rise in prices.
Strong, above-trend, growth so far this year of 10.5% in air cargo volumes and 7.9% in air travel reflects this benign economic environment.
How long can this continue? After all, the previous air traffic cycles of the past quarter century have typically lasted not much more than eight years, and we are in the eighth year of the current upcycle.
Valuations of many asset prices are high relative to GDP or past cyclically-adjusted highs
Often an upturn of inflation triggers a sharp rise of interest rates which brings the cycle to an abrupt halt. There is very little sign of that at the moment. Inflation remains low. But asset prices are not.
Valuations of many asset prices are high relative to GDP or past cyclically-adjusted highs. If central banks make a mistake in unwinding QE or if there is a shock from the Chinese credit boom, then bursting asset price bubbles combined with still high levels of private non-bank debt could trigger the end of the upturn.
Central banks will try to mitigate this risk and any bursting of asset price bubbles is impossible to predict.
However, it does emphasize the need to use the current buoyant conditions to ensure business models and balance sheets are robust to a possibly less benign future.
That’s the external business environment. But we’ve also seen some important recent developments inside the industry.
Consolidation and cooperation is happening in the fragmented European airline industry.
An interesting innovation saw Easyjet announce a scheme to connect passengers through Gatwick onto long-haul services operated by Norwegian and Westjet
This consolidation is no reflection of the overall financial health of the industry in Europe, which is second only to North America, but rather a failure of weak business models for specific reasons.
Air Berlin was declared bankrupt and Alitalia placed into extraordinary administration after the withdrawal of support from Etihad, while Monarch failed as a result of Brexit-related adverse exchange rate moves, the closure of a key Egyptian market, and intense competition.
Ryanair’s troubles and subsequent capacity cuts will reinforce this trend and support the improvement in unit revenues in the second half of this year.
An interesting innovation in cooperation was seen with Easyjet announcing a scheme to connect passengers through Gatwick airport onto long-haul services operated by Norwegian (whose UK-US service has finally been approved by the US) and Westjet.
This may work in the opposite direction to within-Europe developments and add to the emerging fragmentation of the North Atlantic market.
Overall, recent developments suggest the second half of this year will be better than the first half for airlines’ profits globally.
The risks lie further ahead, with uncertainty created by Brexit and the rise of populist pressures on policy
The strong economy and consolidation in Europe should support unit revenues. Fuel costs have spiked higher but other inflation pressures remain low.
There is positive momentum. The risks lie further ahead, with uncertainty created by Brexit and the widespread rise of populist pressures on policy, with creeping soft protectionism and the threat of trade war, not to mention the risk of military war, and with the risks to financial stability posed by high asset price valuations, high non-bank private sector debt and the start of central bank reversal of its QE asset purchases.
The opportunity is to use this benign business environment to further strengthen business models and balance sheets to ensure that the airline industry, in all regions, is robust to a potentially weaker future business environment.