RichardAboulafia.com 

:: February 2020 Letter ::

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Dear Fellow Involuntary Distant Socializers,

This letter is late for a simple reason: itís hard to write when you feel like youíre rolling down a steep hill. The Coronavirus crisis began as a distant problem but has since become a full-blown disaster. At first, aviation people compared the impact on our industry to the SARS epidemic, then to 9/11, and now, something completely different, the worst exogenous shock or most terrifying fanged, clawed, Black Swan yet.

Forecasting in this situation is all but impossible. I can just provide my basic mental framework about what to watch (three things) and how key markets will be impacted. First, here are the indicators to watch, with our current thinking:

1. Traffic, or, more accurately, the virus itself. Is this a deep V-shaped downturn, or U-shaped, or L-shaped? This becomes an epidemiological question, and nobody knows how this disease will unfold. The key metric is the number of new confirmed cases worldwide each week.

Our assumption: A very deep U. That means a strong traffic recovery in 2021, but a really awful 2020. And as weíd seen in 2019, these numbers will be de-linked from GDP, for the obvious reason that many other forms of economic activity can continue even when people canít (or wonít) fly. Until thereís a vaccine, there may be recurring periods of social distancing, and people not traveling.

2. Fuel prices. From ~$50 to ~$25 in just a few weeks. Putinís Russia and MBSís Saudi Arabia are playing chicken with crude output, and neither side is famous for blinking. This fight is effectively a smaller Black Swan, hidden by the much larger Coronavirus one. An oil price recovery, therefore, depends on a demand recovery (particularly in China, but total world demand is down 10% year/year), which probably wonít happen until 2021. Even then, some experts think Saudi Arabia is just determined to outlast everyone with cheap, plentiful oil. Fuel this cheap makes new generation jets a lot less appealing relative to keeping older equipment.

Our assumption: Same as traffic. Cheap gas through 2020, with a recovery to $~50 in 2021. But given the geopolitics involved, thereís even more risk to a recovery here than with traffic.

3. Government intervention. This is not a financial crisis, like 2008, which was dealt with by a financial sector bailout. Rather, the entire economy is crashing, with a complete collapse of demand in many sectors, including aviation. Nobody really needs jets now. As Larry Summers, put it, ďeconomic time has stopped, but financial time has not been stopped.Ē To deal with this demand-side shock, airlines have asked for money ($200 billion globally and $50 billion in the US) to stave off mass layoffs, and Airbus and Boeing have asked for money ($60 billion for Boeing and its suppliers) to keep building jets until airline traffic comes back.

Our assumption: Somehow, governments get their act together, with tens of billions for aircraft production and for airlines. See my next letter for more on this, to follow this one in a few days.

Lower interest rates, however, will have no impact. Again, demand is the problem this time, not financing. And unlike in past crises, interest rates were already very low, so there wonít be much of a stimulant from cheaper cash. But at least lessors will get a modest boost.

Next, markets. With the assumptions above, hereís what weíre expecting:

Twin Aisle Jetliners. This segment will be hit hardest, with rates falling later this year and a more serious drop (20-25% by value) in 2021. There was already an overcapacity problem here, and international traffic will recover slower than domestic. Most programs will be hit, but the A330neo is particularly vulnerable. If Airbus prioritizes the A350XWB, the 330neo could be this generationís MD-11. B787 rates will fall too; hardly surprising since rate 14 was ill-advised.

Single Aisle Jetliners. Not as bad as twin aisles, partly because supply was already constrained (the MAX disaster, and a slower-than-expected A320neo ramp). The big risk here is fuel prices, since, again, the appeal of MAX and neo rests on fuel savings. Look for a flatter Airbus ramp than scheduled. As for the MAX, it might be well positioned for the traffic recovery, but for the next 12-18 months there are more risks in absorbing the 387 delivered jets, the ~350 undelivered jets, and of course the new jets to be built (at a low level). Thatís a lot of capacity arriving in an industry that really doesnít want capacity right now.

Business jets. Whenever something bad happens to airlines (pandemic or terror), there's an anecdotal upsurge in private aviation demand. This has never proven to be sustainable. In fact, business jet demand gets clobbered by crashing equities markets and corporate profits. Again, watch fuel prices. Resource-rich countries and energy extraction companies drive large cabin jet demand, so that segment will likely be hit hardest. Weíre expecting a 20% decline in large cabin rates starting later this year. Small/medium jets will hit a new low, but down just modestly from today since they never recovered from 2008. Bombardier looks uniquely vulnerable in the business jet industry. Theyíre overwhelmingly reliant on high end jets, with no exposure to defense markets. Two months ago, this wasnít a problem, but it now looks very bad. Getting rid of the remarkable Alain Bellemare a few weeks back was a serious mis-step too.

Defense. Defense is defensive, as they say on Wall Street, and thatís true for investors and for supplier companies. So far, no change to our forecasts. The US, EU countries, and Japan arenít likely to cut budgets, but they wonít raise them, either. Defense companies may face workforce issues during the pandemic, and suppliers with heavy commercial exposure may face cash flow difficulties, but the pure play defense primes are in a solid place. As for export markets, a few important ones, like Saudi Arabia, are under pressure due to declining oil revenue. That might hurt the fighter, transport and special mission markets if prices stay low beyond next year. Also, while military helicopters wonít be affected, the civil segment will be hit by the oil price shock.

So here we are. After thirtysomething years tracking aviation markets I thought Iíd seen everything, but apparently I hadnít. What else can I say, except stay healthy, take care of others, and letís hope for better times for our industry.

Yours, ĎTil I Get My Emotional Support Pangolin Back,
Richard Aboulafia
 

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