2019: Cyclical and
Regulatory turning points December 2018

Ten years on from the collapse of Lehman Brothers and the consequent Global Financial Crisis, and it seems that there is no end in sight to a prolonged upturn. The IMF in its October World Economic Outlook forecasts global GDP growth continuing at around 3.6%-3.7%. IATA in its biannual airline forecast update, published in December, suggests that 2019 will see another year of above trend growth in the industry and yet another year of healthy profitability. 

But both hint that there may be an increasing possibility of surprises on the downside. The IMF particularly remarks that expansion has become less balanced between regions and may have peaked in some major economies — and particularly the US. It points to growth rates falling over the next two years as the Trump inspired fiscal stimuli unwind and his trade war with China begins to bite.

For the advanced economies overall it forecasts GDP growth slowing from an expected 2.4% in 2018 towards 1.5% by 2022; emerging markets and developing economies as a whole continuing to grow at around 4.75% (with China’s growth slowing gradually from 6.9% in 2017 towards 5.75%). 

IATA, while recognising help from recent oil price falls, points to unit cost and unit revenue increases in the past 18 months removing some of the “price stimulus” from demand generation. Disturbingly perhaps it is forecasting a modest acceleration in the rate of increase in non-fuel unit costs.

It suggests that 2018 will have ended with an annual growth of 6% in the number of passengers and 6.5% in terms of passenger kilometres (slightly down on the respective 7.2% and 8% rates seen in 2017) while forecasting that 2019 will see a further slow down towards the long term trend with increases of 5.5% in the number of passengers and 6% in terms of RPK.

On airline profits however it is forecasting operating profits and net profits for 2018 and 2019 not too far different from those for 2017 (see chart) albeit reflecting operating margins of 6.8%, down from the peak of 8.6% in 2016. If so, then this decade will have proven to have been the longest period of continuous net profitability in the industry since the mid 1960s. Indeed in the ten years to 2019 the industry should have made a total net profit of $235bn compared with total net losses of $13bn in the preceding 63 years.

As IATA pointed out in a presentation at this year’s GAD World Conference in Hamburg in November, each of the past four cycles have averaged ten years from peak to peak (see chart). Over that period, the total number of airline passengers has grown nearly twelve-fold from 380m in 1970 to a possible 4.5bn in 2019, a compound average annual rate of 5%. The average length of haul has grown by an average 1% a year, and RPK by 6%.

Intriguingly since the peak of the last cycle in 2008 there has been an increase in the growth rates of passenger numbers (but a slowing in the growth of average length of haul), and in each of the past four years growth in demand has remained well above trend. This can mean one of two things: either there are 500m passengers a year who will stay at home come the next downturn, or the industry trends are changing.

And the downturn will no doubt come even though it is difficult at the moment to see the catalyst. The stock markets seem to be anticipating that it will come sooner rather than later: it is almost as if the “teenage scribblers” believe that not having seen a recession for ten years, one must be due soon. The US S&P 500 index ended 2018 6.25% down on the year and 15% down from its peak — its worst year in a decade; London’s FTSE 100 ended 12% down on the year and 15% down from its peak; Japan’s Nikkei and Hong Kong’s Hang Seng indexes each down by 14%; and China’s CSI 300 index down by a massive 25%.

Furthermore the US Government bond yield curve, while not quite in reversal, has flattened considerably in the past year suggesting increasing concerns over the trajectory of the US economy and the trumpery of disagreements between the executive and bodies political and fiscal. 

The danger may be that the world is being beguiled into thinking that because historically it is time to have a recession, there will be one. This expectation process is integral to Keynesian economic cycle theory. 

However, the peak of each of the past four cycles in the airline industry have been signalled by some luminary of the industry stating the “this time it is different”. None has yet been brave enough to state the same sentiment.

Brexit

There are foreseeable risks, and one of those is quite what happens when (if?) the UK leaves the European Union at the end of March 2019. We have written extensively in the past year in Aviation Strategy (see the April and September issues) on possible outcomes but with less than three months to go before the deadline we still have no idea what will really happen. 

The UK is an important part of the airline industry. It ranks as the third largest country in the world by air passengers (to, within and from) after the US and China, and despite constraints at Heathrow and Gatwick, London is the gateway to Europe. And yet the divorce from Continental Europe has the potential substantially to disrupt its economy (severely impacting outbound demand) and create significant doubts over the ability of its major airlines to continue to provide service. 

A report from the influential National Institute for Economic and Social Research (NIESR) in November estimated that the Government’s current proposed exit deal would reduce the UK’s economic performance by 4% by 2030 compared with remaining within the trading bloc, and that an orderly divorce without a deal would have a 5.5% negative impact. The Bank of England presented an assessment that falling out of the EU in a disorderly fashion would plunge the UK into a deep recession possibly pushing GDP down by over 10%. The main question is whether the UK leaves with or without a deal.

The EU has stated that air transport services, in the absence of any deal, will be confirmed as basic third and fourth freedom rights, but that it will enforce ownership and control rules. And it will be the requirement that UK airlines will have to be majority owned by UK nationals, and EU airlines majority owned by EU (ex UK) nationals that could be a stumbling block. 

The UK meanwhile has negotiated new open skies agreements with the US and Canada (and a handful of other really important countries such as Albania, Georgia, Iceland, Israel, Kosovo, Montenegro, Morocco and Switzerland) effectively to maintain the status quo. The US agreement includes the usual ownership and control rules, but provides for a grandfathering of current operators' rights as long as majority shareholders are nationals of countries with liberal air service agreements and have “high labour standards in respect to air transport”.

This is particularly important for Delta which, when Richard Branson finally sells a stake to Air France-KLM, will have effective control of Virgin Atlantic. But the DoT waived the opportunity to block Norwegian’s North Atlantic operations from Gatwick. 

But there are also unsolved ownership issues relating to British Airways (and its Spanish registered parent IAG), easyJet and the UK’s third largest airline, Irish registered Ryanair. 

In December the UK Department of Transport published a consultation document “Aviation 2050: The future of UK aviation”. Its proposals include full liberalisation of air traffic rights, fostering multilateral open skies agreements, full interchange of equipment and to move to a definition of a UK airline as one that has its principal place of business in the UK.

This was an airline designation model originally proposed by ICAO as a clause for inclusion in air service agreements nearly 20 years ago, but only so far adopted by Chile (and the Andean Pact signatories), Costa Rica, El Salvador and (for domestic services) Australia and New Zealand. 

A key question may be how likely the UK will be able to be able to introduce these proposals and foster their introduction on a multilateral basis. This, pragmatically, will depend in part on the way in which the EU responds to its treatment of BA, the UK’s flag carrier, and it and its parent company’s status.

These proposals could well form the model for a new aviation world, and may even create the opportunity for global consolidation in the industry. If so it will be ironic that it will be as a result of Brexit.

Interesting times!