The holiday period at the end of each year provides a time for reflection, on what has happened in the last twelve months, and for contemplation of what might happen over the next year. Whilst it will be some time before we will know the actual outcome for 2016, it is reasonable to assume that at an industry level it may not be materially different from that of 2015. Similarly there will be a wide variation in experience; indeed in some regions that performed well in 2015, the results to date from the local airlines show a quite different outcome this year, showing a marked turnaround in financial performance and in this respect the Gulf would appear to provide a case in point.
Results only tell us what has happened and, in this respect, are history, although not only do they set the scene but a number of what were clear trends in 2016 are also likely to be evident in 2017 too. Against this background the three trends that stand out are still; excessive capacity growth, rising fuel prices, and the continuing strength of the US dollar, although some consider that it may have receded from recent peaks, the greater likelihood is that as interest rates rise in the US so will the dollar again.
There is another factor that has come to the fore and that is uncertainty; even the most cursory glances at the so-called “uncertainty indices” provide very clear evidence of how uncertain the world has become whether from an economic or geo-political point of view. Uncertainty impacts upon consumer and business sentiment where the default outcome is to stop spending.
If we look at current forecasts for GDP into 2017, passenger yield neutral capacity growth is in the order of 3-4% at an industry level compared with an expected capacity increase of some 5.6% for the year to September 2017 according to the latest DIIO data. Somewhat worrying, but unsurprising, is that real labour productivity (which is measured with a reference to either cost or revenue) continues to deteriorate at an industry level. Against this background it is reasonable to expect a decline in yields of some 4% in real terms but with no amelioration from lower fuel prices. Indeed we see the continuing fall in fares as a structural change and it seems to us that the notion that fares will increase as fuel prices rise to be misplaced and indeed there has been no evidence of this taking place as fuel prices have risen from their early 2016 low point of $0.93 a gallon to $1.48 now. Indeed average fares in 2016 appear to have fallen by some 10-11%.
Although a eurocentric view, the number of promotional offers that we receive from airlines every day, and the current advertising campaigns, provide clear, albeit anecdotal evidence of the pricing environment and one where customers will continue to benefit.
Forecasting the near-term development of the oil price is always a challenge given the impact of amongst other things geo-political events and decisions. It was however of interest to see one of the charts in the Bank of England’s latest quarterly report which highlighted how oil demand was now ahead of supply – but here it will take some time to see whether this is a re-setting of the balance or just a temporary or seasonal factor. Not only has the ability to absorb lower fares with a falling fuel price gone but, with fares still falling and fuel rising, the impact on margins is inevitable although hedging may act to delay the full impact.
We highlight the risk to profits posed by the strength of the US dollar to airlines where the dollar is not their “home” currency. Indeed whilst the general expectation is that the dollar will strengthen further it is important also to look at the external value of other currencies too which will be determined by local economic conditions (including the path of interest rates); a country’s currency is after all a sign of its economic health. In this respect the € appears fundamentally weak and with a series of elections in key member states including France, Germany and the Netherlands due to take place in 2017 against the background of dissatisfaction on the part of voters, the € is likely to weaken further over the course of the year. More parochially the value of £ sterling will be determined by the news-flow, and the interpretation of the news-flow, around the Brexit negotiations and indeed any comments regarding a so-called “Hard Brexit” will push the value of the pound lower.
Turning to the supply side, we have already seen some announcements regarding aircraft deferrals most recently with Emirates and the A380; we would expect more across the board as 2017 progresses. Indeed whilst we may now be focused on the results for 2017, attention within airlines is already on 2018 and beyond where we would expect the environment to be more demanding still. However, we would expect capacity growth to moderate where one of the mechanisms is through aircraft coming off lease and not going back into the market; something that could have a meaningful impact on residual values and on lessors and other financiers realising the value of the equity they have in an aircraft which, for some, may be a painful financial experience but, as ever, an opportunity for others.
Furthermore, at the simplest level, the strength of the dollar also makes new aircraft more expensive and more difficult to make the economics work against the background of falling yields. Whilst new generation aircraft demonstrate greater fuel efficiency, the greater attraction of new narrow-body aircraft has become the increased range that they offer. That the book to bill ratio for the manufacturers has fallen below one should come as no surprise at all and indeed it is reasonable to expect the number of new orders in 2017 will be lower still and where attention will also be focused on late notice “switches”/deferrals; at the same time “pre-owned” narrow-body aircraft should continue to increase in attractiveness and provide an alternative source of supply to new aircraft which in terms of their home currency will continue to become more expensive; something that may delay the crystallisation of residual value losses.
If anything, recent events only act to reinforce the view that the only constant is change. Whilst the elements that are changing are broadly the same ones as in the past, they happen to be three of the more important variables which determine the performance at the level of an individual airline. If anything the current outlook for 2017 is likely to be on the optimistic side where “downside risk” remains, something which will become clearer as the year progresses. As ever managing in changing circumstances will be an important attribute of all leadership teams whether the changed circumstances result in opportunities or challenges, but one thing is certain 2017 is unlikely to be dull.