:: November 2008 Letter ::


Dear Fellow Credit Risks,

Years ago my mom gave me a pretty objet d’art known as depression glass. It has an interesting back story. The glass factories of West Virginia and nearby states, built during the go-go 1920s, found themselves without business after the depression struck. They had the capacity, they had the people, but they were reduced to selling their fine quality products for almost nothing to movie theaters and store owners, who used the glass as an incentive for customers to come see a movie or buy something. This bowl is a pretty yet chilling reminder of a painful era of deflation: too many goods, and not enough money.

The odds are against serious deflation. If politicians keep cheapening capital and dumping liquidity in the system (partly to prevent deflation), we could even have inflation. But consumer prices fell by 1% in October, the sharpest drop in Consumer Price Index (CPI) history. Retail sales that month were down 4.1% from a year ago. Unemployment is way up, along with bankruptcies. The S&P is down by 50%. Equities markets elsewhere generally have it worse. If this is a serious recession with deflation, or an outright depression, the impact on the aviation business will be profound. It might be some time before our wealth catches up to afford all the planes we’ve built and ordered.

The first impact is Travel Demand. Unlike my dad’s family, and most of the world, my mom’s family did okay in the depression. That’s because her dad made clothing, which is the opposite of air travel in demand elasticity. Air travel is heavily discretionary and therefore elastic. As traffic falls, there are no safe havens anymore. Even resource-rich markets are suffering due to dropping commodity prices. International Air Transport Association figures for September showed Mideast traffic dropping for the first time in many years, falling 2.8% over September 2007 (but with growth recovering to 3.5% in October). This is the hyperfast growth region where three carriers, counting on double-digit traffic growth, hold 35% of the A380 and nearly half of the A350 order books. If this global downturn turns down further, we could be looking at a severe market drop followed by a painfully slow recovery.

Then there’s Financing. As I mentioned in my September letter, jetliner financing is in respectable (i.e., not great, but not catastrophic) shape. But there are still too many planes and not enough cash, and lease rates are under pressure. The market is buffered by large fleets of older jets to cut, but low fuel prices make older jets more attractive than new ones. Meanwhile, largely due to financing issues and falling corporate profits, the business jet market is in much worse shape. Used business jet availability has risen sharply, with 14% of the fleet up for sale and prices falling too.

As we shriek for the government to save us, there’s a big risk: the government might try to save us. The next concern: Stupid Business Bailouts. A government-funded industrial policy, seldom a good idea, means promoting potentially successful businesses with public money. A government-funded industrial policy gone horribly wrong means promoting loser businesses with public money. If an auto industry bailout proceeds and is followed by bailouts for other job-intensive sectors, the government would be taxing successful industries like aerospace to prop up losers like GM (taxing successful auto plants in the South and Ohio to prop up GM is bad too). That’s a dumb-as-dirt way to run a country. Also, if the car bailout goes ahead it would seriously complicate the US WTO jetliner subsidy complaint. Europe could retaliate with a far more effective car subsidy complaint.

The fourth horseman of the apocalypse is Protectionism, another example of politicians hurting by helping. It’s the phrase on everyone’s lips: Smoot-Hawley Act. Okay, it isn’t really on everyone’s lips, but it should be. This nasty little pro-tariff/anti-trade bomb was one of the first weapons wielded by Congress in its response to the 1929 crash. A foolhardy effort to protect US jobs, Smoot-Hawley exacerbated the crash by choking global trade. It could happen again. There’s a dangerous anti-trade tendency endemic in the US body politic (fun fact: noted trade-hater Lou Dobbs makes $6 million per year “defending the Little Guy”). The Obama campaign’s trade doubts were probably just talk to get the union vote (most Obama appointments have been free traders), but they could turn into policy if the public demanded protection. On the other side, anyone at a Sarah Palin rally who owned a passport was a freakish oddity — the populist wing of the Republican Party is as anti-trade as the Democrat’s left wing. In tough times, free trade has a hard time finding friends.

Resurgent protectionism could endanger access to the US defense market for international players such as EADS and Finmeccanica as politicians favor domestic companies and jobs. It will make cross-border acquisitions more difficult too. Ending international air travel liberalization would damage the airline business, especially if it was coupled with re-regulation. In a worst case scenario, there could even be a return to commercial jetliner trade barriers. There are many nationalist losers on both sides of the pond.

Finally, there’s Defense Spending. There’s no historical connection between economics and the defense budget. People support military spending when they need it, not when they can afford it. Yet there’s no way to spend $2 trillion bailing out everybody with a pulse and not hurt future discretionary spending, including defense. In budget deficit and national debt, we are now deep into uncharted territory. Given the post-Iraq state of the military, reduced recapitalization funding will mean older equipment and weaker forces. For years, historians have proposed or rejected strategic and economic parallels between the US today and Britain back in the 1940s. They’re starting to look quite similar as examples of imperial overstretch. Hopefully the decline in US military budgets and capabilities (and US global relevance) won’t be as terrible as the UK’s decline after 1945.

These five concerns reflect a worst case scenario: that much of the wealth created over the past twelve years was based on incurring massive debts, and after endless postponements, the bill has finally come due. We’re left with much less money than we thought, we’ve built and ordered too many jets, and there are too many available seat miles. The result of this great de-leveraging would be a decade (2010-2019) of lost growth, an era shaped by scarcity and, possibly, bad government and isolationism (also: social security is a mess, infrastructure is crumbling, the environment’s wrecked; those bills are due too). Aircraft production in this god-awful scenario could be less than in 2000-2009.

Like any worst case scenario, it’s unlikely to happen. People are hoarding cash now, but there’s a lot of wealth out there. When the debt and asset valuation problems improve, money will come back, lifting markets. Cheap oil helps the economy, especially airlines. By comparison with the recent CPI drop, consumer prices fell 25% between 1929 and 1933, a far more serious problem that puts today’s minor deflation in perspective.

We’re taking a moderately gloomy position, but with a light at the end of the tunnel. As a result of this year’s chaos, we’re at the start of a severe down cycle, worse than the past few downturns but not a depression. Think of it as a very serious bubble popping, but nothing worse. Our baseline scenario calls for a jetliner deliveries recovery by 2014. But forecasting in a time of extreme uncertainty is almost impossible. Remembering my parent’s depression stories, I wouldn’t want to be making glass today. Or A380s.

Yours, Until Movie Theaters Give Away 737NG Leases,
Richard Aboulafia


© Richard Aboulafia 1997-2006, All rights reserved.
  ~  Last updated on January 08, 2006