The Global Macroeconomic Outlook And Implications For Airline Profitability

Transcript

Brian Pearce:Peter's asked me to talk about the global macroeconomic situation and its impact on airline financial performance. I'm also, though, going to talk about what I see as some of the structural changes that we've started to see. Thank you, Brian. see in the airline sector because I think they're really important. And since we've got Boeing and Airbus talking here, I'll put in a little bit at the end about what we see as some of the issues on the longer-term outlook. I mean, let me just kick off by saying, you know, clearly the macroeconomic environment matters for air travel and also for cargo. You know, since the start of commercial aviation, we've seen ups and downs in our industry, you know, tightly linked to the health or otherwise of the global economy. Obviously, travel and also cargo are actually very leveraged to the economic cycle. So clearly, macro matters. Interestingly, I think, We used to say the same about airline financial performance. You know, up until the global financial crisis, airlines' financial performance, their profitability, was very tightly linked to the economic cycle. You know, airlines typically did really well when the economy was strong. They went out and ordered lots of shiny aircraft, and they were delivered, of course, just when the economy was sinking. recession, and profits were crushed. And so we had this cycle in the aviation— in the airline sector, which resulted in— actually, since— if you look pre-global financial crisis, the net profit margin of the airline sector ever since the start of the industry on average was zero. Before the global financial crisis, airlines managed to pay their bills, they managed to service their debts, and there was zero left over for providers of equity. It was clearly an unsustainable situation. As you can see, that seems to have changed in recent years. And I'd certainly argue it's more than fuel. People— everyone who put fuel as the most important issue today, I'm not sure it is. You know, we've had a long period in the '90s where oil cost $20 a barrel, airlines lost money. We had that period after the global financial crisis where a barrel of crude oil cost you more than $100 a barrel, jet was a lot more than that. Actually, airlines were improving their financial performance and people were traveling. You know, I don't think fuel is the key issue here. I do think, though, we need to come back to see, you know, are there structural changes in what airlines are doing here? Because certainly the financial markets, I think, are skeptical. We haven't seen the improvements in price-earnings multiples or indeed in credit ratings that you might expect if this chart suggests that there's been a structural change in the way that airlines are performing, have decoupled to some extent from the cycle. So it's probably, I guess, you know, maybe it'll take a recession to convince financial markets that things have changed. And if we look at the, you know, the history of cycles in air transport here in RPKs. I guess the first takeaway is downturns are pretty much speed bumps for air transport, for air travel. You know, we've been an industry, incredible growth industry, and I'm sure we'll be a growth industry in the future. I guess the debate that perhaps we'll have a little later is on the slope of that upward line. You know, how strong is that going to be in the next 20 years? I'll come back to that. Second takeaway is that, you know, typically cycles— you know, we've had periods of expansion that have lasted between 8 and 11 years before we've had a downturn. And this current expansion period is 10 years old. giving rise to lots of speculation, you know, when's it going to end? I guess I would point out that the factors that have ended previous cycles have all been what Donald Rumsfeld would have called unknown unknowns. We couldn't really have predicted them with any certainty. Cycles nowadays are not regular, inevitable things. They're typically shocks. So— In some senses, that's reassuring. It's not going to end automatically. On the other hand, we might well be surprised. We will be surprised. And it's as well, I think, to make sure our business models are robust to the next shock. But certainly the consensus is we're going to have continued expansion next year. Yes, business confidence has dipped. You can see here from the blue line, business confidence is not what it was, but it's still pretty good. Businesses are still expecting expansion. And the red line shows the Oxford Economics economic forecast. The IMF's is pretty much the same. You know, they're expecting slower growth, but, you know, it's still— that's still pretty, pretty good. So that's positive. On the other hand, what it does mean is that we're running out of spare capacity. And this is the OECD's view of the world, and it shows that the main economies in the world have essentially used up all the spare capacity that we saw after the global financial crisis. Cost pressures are rising. Unemployment has gone down to below global financial crisis levels. Crisis levels. Wages are rising. And, you know, it's going to take a recession to stop that. So I think the biggest challenge— I know we've put fuel on there, but I think it's a more general issue. The biggest challenge that we face as an industry over the next couple of years is going to be dealing with higher costs. And in fact, we've been dealing with that for the last year. You know, we've We've moved beyond that period where we were facing falling unit costs to, you know, quite a reasonably strong increase in unit costs over the over the past year. And as I say, that is set to continue. We've typically looked at issues in our own industry, you know, pilot shortages. We've had a lot of labor issues, and also, of course, jet fuel prices. But I think this is reflective of a broader issue. For a long time, you know, the industry was able to pass those costs through either in higher yields or higher load factors. That seems to have faltered a little. There's some relief on fuel. We've seen fuel prices spike and then fall back down again. Obviously, there's a lot of volatility in supply decisions in OPEC, but I think the new kid on the block is the US, and despite the pipeline problems, we're actually seeing a really sharp increase in supply of US fuel. I think medium-term though, it looks as though we're going to be, you know, in a higher fuel cost world. But let me move to that second chart which showed that there have been some changes in financial performance from the cycle. I think the first change has been with the nature of the airline product. We've seen ancillary services forming much more of the package sold to the consumer. I think that's an important structural change. And so the changes in distribution that we're seeing a really important part of that. And IATA's been putting out a new standard, the new distribution capability, which allows airlines to distribute ancillaries indirectly through travel agents. I think the second change has been airlines are now managing their capacity, their asset utilization, in a very different way to pre-global financial crisis. And if we look at load factors compared compared to breakeven, it's very different to where it was before then. And you can see this change, and the gap between these lines drives profitability and return on capital. It's a very different picture to what we saw pre-global financial crisis, and it started before the fall in fuel prices. So what we've seen in airlines' performance, you know, is not just because of low fuel costs. Brian, And I think it won't completely disappear with higher fuel prices. And, you know, when we're looking at return on capital, which is probably the key metric for airlines' financial performance, it's not just margins on revenue, it's also the amount of revenue airlines can actually squeeze out of their assets. Ancillaries are an important part of that, but also things like densifying seating and the way in which airlines are using their fleet is also critical here too. So I'd argue that there are some structural changes that will mean that the— there is some downside protection in more difficult business conditions. But let me just finish with a longer-term concern. I think the world has changed. I think we're in a much more protectionist world, and I don't just point to the tariff wars. I think we've seen a change since the global financial crisis, and you know this line shows that world trade no longer grows faster than GDP, and it hasn't done for the past decade because of soft protectionism and most recently because of the tariff wars. I think that calls into question one of the key drivers. Of air travel, of the growth that we've seen. We've got a rule of thumb in the industry of, you know, 5% growth a year. That's gonna— that's what we've had in past decades. Surely that's gonna continue in the future. Price stimulation has been an important part of the past, you know, with liberalization in the US, with liberalization in Europe driving some big falls which probably added 1 to 1.5% on average to growth in air travel a year. Is that going to continue in the sort of world that we have? You know, we've put together a few scenarios looking at the future, and the future could look like the past if we return to a more open borders world, and we could see expansion of 2.7, 3 times over the next 20 years. But I think it does depend on us, us, everybody else persuading governments that we need to move away from closed borders, border frictions, back to the more globalized liberal world that we lived in. And if we don't succeed in doing that, then yes, we will see growth. You know, there are some pretty strong drivers in Asia-Pacific, but it could be a You know, a rather disappointing expansion. Thank you.

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