Brexit and aviation Part 2: lower air traffic, economic uncertainty. UK-EU relations up in the air
The British exit from the European Union will have a negative impact on UK air traffic as a result of weaker GBP – an immediate effect – and a weaker GDP outlook. Air freight is also likely to be negatively affected by lower levels of international trade. The impact on air traffic is also likely to be felt in the rest of Europe, while economists are also warning that Brexit adds to the uncertainties facing the global economy.
European airline share prices have been hard hit since the UK referendum result was announced early on 24-Jun-2016, particularly those of easyJet and British Airways' parent IAG. This reflects the likely lowering of demand, but also the significant regulatory uncertainty surrounding the sector, particularly with respect to market access.
UK membership of the European Common Aviation Area would preserve existing market access and is the expected route. However, UK political turmoil and question marks concerning its ongoing commitment to EU principles may compromise its access in the future. Profit warnings from IAG and easyJet point to at least a slowing of profit growth. It is difficult to see the world airline profit cycle continuing the upswing of recent years.
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Brexit to hit air traffic demand through lower GDP, weakening of GBP and lower trade volumes
From an economic point of view, Brexit is likely to have a negative impact on air traffic volumes in three ways.
Firstly, there is a well-established relationship between GDP growth and growth in passenger traffic, so any reduction in economic growth in the UK (and/or the rest of the EU) will be detrimental to demand for air travel.
Secondly, the fall in GBP versus other currencies – in particular EUR – that has taken place since the referendum is effectively a price change for UK airlines' air fares and this will affect demand due to price elasticity.
Thirdly, air cargo volumes are closely related to levels of international trade, which are themselves affected by economic growth and trading agreements between nations.
Lower GDP could lower UK pax by 2.5% to 5.5% in 2020
Perhaps the most comprehensive summary of the economic impact on air traffic of the UK's decision to leave the EU came from IATA in a 24-Jun-2016 report. The IATA report reviewed a number of scenarios on impact of Brexit on the level of UK GDP that have been produced by different forecasters: the UK Treasury, the OECD, the National Institute of Economic and Social Research and the Confederation of British Industry/PWC.
Depending on the forecaster and on the nature of the (yet to be agreed) future trading relationship between the UK and the EU, UK GDP is expected to be lower in 2020 by 2.5% to 5.5% compared with the 'no Brexit' baseline.
Although developed markets have been estimated to have an income elasticity of 1.3 at a national level, IATA conservatively suggested applying an elasticity of 1.0 between GDP and air travel. Based on the estimates of the GDP impact of Brexit, this suggests that UK passenger traffic will be lower in 2020 by 2.5% to 5.5% than it would have been if the UK had remained in the EU.
Economic impact not only to be felt in the UK
In addition to the impact of Brexit on the UK, the economic fallout may also dampen economic growth in the rest of the EU. The UK is the biggest aviation market in Europe and any softening of air traffic demand there will be felt across the continent.
Since the UK referendum economists at several leading investment banks have revised their GDP growth forecasts downwards for both the UK and the eurozone. Goldman Sachs now expects the UK to enter a mild recession by early 2017, and forecasts only 1.25% growth for the eurozone over the next two years.
Some, such as Barclays, have warned of the UK entering a period of stagflation (inflation and slowing/no economic growth). In a reminder of the inter-connectedness of the global economy, Bank of America Merrill Lynch has also warned of a potential negative impact on US GDP growth.
Economic forecasts can be notoriously inaccurate, but even if the precise numbers do not turn out to be right, the downward revision to forecasts is often a sign that the economic cycle is moving into a downswing. Moreover, IATA has rightly stressed that the impact of Brexit would be a permanent downward shift in the level of GDP, rather than a temporary impact that would be recovered over time.
As CAPA has previously suggested, the world airline industry has enjoyed record high operating margins in 2015 and 2016. CAPA's industry margin model currently predicts a peak in 2016, followed by a modest margin decline in 2017. The model is due for its six-monthly update in Jul-2016, but the signs currently are that the airline sector's cyclical upswing of recent years will be difficult to maintain. There were already significant macroeconomic and geopolitical uncertainties, and Brexit adds further clouds to the outlook.
See related report: CAPA global airline financial outlook
Weaker GBP could lower pax by 1.7% and 2.9% over next two years
The more immediate economic impact on air travel to/from the UK comes from the drop in the value of GBP. Although many analysts predict that it will recover to some extent over the medium to long term, GBP is expected to stay 10% to 15% weaker than it would have been if the UK had remained in the EU.
The weaker GBP makes it more expensive for UK residents to make outbound trips to other countries, but it has the opposite effect on overseas visitors to the UK. Due to price elasticity of demand, this will reduce outbound air travel from the UK and increase inbound travel.
Because the UK market has more outbound traffic than inbound (53.9 million UK resident trips by air overseas in 2015, compared with 26.2 million inward visits), the net impact on air traffic is expected to be negative. According to IATA, and based on UK Treasury forecasts of exchange rates, the net impact on UK air passenger numbers is expected to be a reduction of between 1.7% and 2.9% over the next two years.
UK trade volumes could fall by 10%-20% by 2030
The impact on the UK air freight market is less certain, according to IATA. The UK's exit from the EU, when that finally happens, will have an impact on its trade with other nations. At the moment the nature of the UK's future trading relationship with the EU is very uncertain.
The UK has not yet triggered the formal exit process, and when it does there will be a raft of complex negotiations to be made that will continue for at least two years (the minimum time frame envisaged under Article 50 of the Treaty on European Union), and possibly much longer. Moreover, in addition to the UK renegotiating its trading relationship with the EU, the way in which the UK trades with non-EU nations is also likely to change post-Brexit.
Notwithstanding these huge unknowns, the OECD has estimated that UK trade volumes could fall by between 10% and 20% by 2030, relative to a no Brexit base case.
European airline share prices have been hit badly
The reaction of European airline share prices to the referendum result has been predictably negative. This partly reflects a cold evaluation of the impact on demand, but is also the result of a more hot-headed fear of uncertainty.
Investors have been understandably spooked by the negative impact Brexit is likely to have on air traffic, as highlighted by the IATA analysis outline above. Moreover, airlines are generally seen as cyclical "bellwether" stocks, to be avoided in any situation of economic uncertainty.
In addition, and more specifically, there have been profit warnings from both IAG and easyJet in connection with short-term demand softness, both in the run-up to the referendum and in the outlook this summer.
However, more than that, airline shares are suffering because of the broader regulatory uncertainty surrounding the sector, particularly surrounding market access. Even if the UK maintains existing market access through membership of the European Common Aviation Area (ECAA) and becoming a non-EU party to the EU-US open skies agreement, demand for air travel will likely be hit by lower GDP and exchange rate movements as discussed. If market access is not fully retained, the impact could be greater and is harder to define.
Uncertainty often leads to share prices overreacting, but most investors are unlikely to be brave enough to start buying back into airlines until more clarity starts to emerge.
Meanwhile, lower prices could possibly stimulate some corporate buying activity, although significant consolidation within Europe also seems an unlikely consequence for now. Interest from airlines outside Europe may increase, but they too will have to satisfy themselves that the uncertainties are fully reflected in share prices.
See related reports:
European airline share price movements from 23-Jun-2016 to 27-Jun-2016*
The UK's future access to aviation market to mirror its wide Single Market access, but political uncertainties are vast
If the UK does not continue with full access to the single aviation market through the ECAA it may be necessary for UK airlines to establish minority-owned affiliate airlines to operate within the EU, and for EU airlines to establish affiliates to operate in the UK. This would be a less satisfactory situation than the status quo, reducing the efficiency of operations.
Part 3 of this CAPA series of reports on Brexit and aviation considers this in the light of experience in other parts of the world, notably Asia Pacific.
The level of aviation market access between the UK and the EU will probably mirror the level of access that the UK negotiates more widely to the European Single Market.
During the referendum campaign prominent members of the Leave campaign suggested that the UK would not want continued full access to the European Single Market, because they did not want to continue with the free movement of people (a necessary condition for full access). During the referendum campaign concerns about the levels of immigration into the UK from EU nations were important to those voting to leave.
However, although the Leave campaign won the referendum vote it does not represent the UK government, or even a single political party. The campaign's leaders have no mandate to commit the UK to any particular version of the UK's future relationship with the EU.
This will be a crucial decision for the UK when it enters exit negotiations with the EU, but seems unlikely to be taken before a new Prime Minister is chosen to replace David Cameron – who has promised to stand down by Oct-2016. His successor will be chosen by members of the governing Conservative party.
It is now generally expected in the UK that the next Prime Minister will probably come from the Leave side of the referendum debate (there were senior Conservative politicians on both sides), but this is far from certain. As yet, no candidates have officially declared that they will enter the race.
There is an additional complexity in that the majority of UK members of Parliament were in favour of the Remain campaign and any future UK-EU agreements will have to be passed by a majority of MPs.
Parliament might therefore be expected to push for deals that replicate the status quo as closely as possible, although their electorate may be at best lukewarm on the continued free movement of people that would be necessary to achieve this.
Moreover, there is also a possibility that a new Prime Minister, chosen only by the Conservative Party, may seek a broader mandate from the British electorate by calling a General Election.
Add to the mix a possible leadership challenge in the opposition Labour party – whose MPs are increasingly discouraged by its leader Jeremy Corbyn (in spite of grass roots support for him among party members) – and renewed noises for a second Scottish independence referendum, and the picture emerges of a UK political landscape that is more uncertain than anyone can remember.
ECAA seems the most likely mechanism, but nothing is certain
The ECAA agreement requires that participating countries have "a close economic cooperation" with the EU, although this is not clearly defined in detail in the agreement. It certainly seems possible that the UK could only be permitted to remain in the ECAA if it agreed to EU principles such as the freedom of movement of people.
Given the uncertain political environment in the UK currently, and the importance to many voters of controlling immigration, it is conceivable that a future administration could reject any deal that requires this.
There are other options for the UK in its future arrangements with the EU on market access, but they also either involve accepting EU rules on freedom of movement, or lesser degrees of market access.
See related reports:
- Brexit up in the air: implications for aviation if the UK votes to leave the European Union
- Brexit and aviation Part 1: Open Pandora's box and anything can happen. But status quo is likely
Restricted market access could potentially lead to increased air fares
If the UK is unable, or unwilling (for whatever reason), to replicate the existing market access arrangements for airlines post-Brexit, this could potentially lead to higher air fares.
The LCC revolution in Europe was largely the result of market deregulation in the 1990s. The increase in competition that flowed from this was one of the factors leading to lower fares.
Any reversal of this process, leading to increased restrictions on market access (eg by UK airlines on intra-EU routes, not just from the UK to the new EU, or by EU airlines flying from the UK to third party EU countries), could result in fare increases. Consultancy Oxera has estimated that such restrictions on market access could lead to UK passenger fares rising by 15% to 30%.
Brexit has even raised questions about the whole future of the EU
The air of political uncertainty hanging over the UK currently has, at least to some extent, also started to leak into the EU. Some commentators see the UK's exit as triggering anti-EU sentiment in other European nations.
The eurozone, which is at the core of the EU (even more so once the non-EUR UK has left the bloc), has struggled economically since the global recession and still not returned to fully healthy levels of GDP growth. This will not be helped by Brexit. Greek debt problems are also still in the unresolved "kicking the can down the road" category and underlying talk of Grexit continues, while anti-EU forces in several EU countries have been invigorated by the UK action.
The big EU powers – Germany and France – remain committed to the so-called European project, but there are murmurings across the continent, previously unthinkable, that the very existence of the European Union could now be under threat following the UK's decision to leave. This remains an improbable scenario, but it adds to the uncertainty faced by investors in European airlines.
Assuming that the EU does continue to exist into the long term, the ECAA still seems the most likely mechanism for the UK to continue the status quo in terms of aviation market access, but it is not a foregone conclusion that this will be possible.
Aviation, like other areas of economic, political and cultural activity involving the UK and its relationship with other nations at the moment, is flying without a map. British phlegmatism is going to be needed in large quantities.