:: May 2010 Letter ::


Dear Fellow M4 Sufferers,

Sometimes two analysts can be twice as wrong. Two years ago on our drive out to Farnborough Aerostrategy’s Kevin Michaels and I discussed the dramatic events of the week. As a colleague recited a grim litany of headlines covering massive government bank and corporate bailouts, we added up the unbelievable sums. The numbers were on a completely different scale than the ones we work with in the aerospace biz. “One thing’s for sure,” Kevin opined, “we are all in.” I immediately agreed. In poker terms, we had gone all in and we didn’t have any more cash to play with.

We were, of course, a long way from all in. As the crisis worsened much more cash was dumped into the economy through programs like TARP and many others. This made the amounts we discussed that hot English July day seem trivial. Actions taken by the Bush and Obama administrations, and other governments, probably saved the world from economic calamity. But the developed nations were left with extremely serious deficits and a nasty debt hangover. Europe avoided the US’s level of stimulus spending, but the current fiscal crisis induced by Greece and the other wonderfully-named PIGS guarantees an even deeper hole for the EU. In all, it took the developed world longer to get there than we thought, but eventually we really did go all in.

From a narrow and parochial aerospace perspective, this cash avalanche worked wonders. We should have had a dreadful bust cycle. The economic indicators clearly point to a 30+% jetliner production drop. Instead, aggregate aircraft output rose 7% by value last year. Light and medium business jets got hammered, but the much larger jetliner segment expanded by 13.5% (about half of this growth was due to the end of 2008’s Boeing strike). The industry benefited from government largesse in five big ways:

1. The broader economy. Bailouts, stimulus packages, TARP…a whole host of prompt actions by the Bush and Obama administrations, along with governments worldwide, dumped liquidity into the economy. Some of the individual steps looked dumb and/or wasteful, but as a whole they prevented a serious meltdown that would have crushed travel and freight demand for a much longer period of time.

2. Bank stabilization. Actions taken to stabilize major financial institutions such as AIG, RBS, CIT, and others forestalled massive fire sales of the aircraft. Imagine if AIG needed to force ILFC to dump its portfolio on the market to generate cash. Repeat that with a few other lessors and you’d have seen the mother of all jet gluts.

3. Ex-Im Bank and Export Credit Agency finance. The backstop financing they provide is helping out with 35-40% of transactions. See my December 2009 letter for more on this.

4. Government jetliner finance. In addition to the ECAs, government-owned banks like Bank of China and sovereign wealth funds have confidently gotten into jetliner funding, even as private sector cash got scarce.

5. Heavy defense spending. A few wingnuts decry “Obama’s defense cuts,” but the FY 2011 budget is bigger than any we had under George W. Bush. A $140 billion procurement budget is as good as it gets.

So, with government printing presses in overdrive, the industry is in good shape. Teal Group is no longer forecasting any kind of serious downturn in the next few years. Effectively, the manufacturers bet correctly that traffic numbers would recover before jet demand fell off a cliff, and governments assumed the burden of financial risk and industry overcapacity. Our 2010 jetliner forecast calls for a 4% decline by value from 2009, but this is due solely to a temporary dip in 777 numbers and the transition between the 747-400 and -8.

If everything were sunshine and brightness, well, this wouldn’t be a Teal aircraft letter. What to worry about? Two things. First is the rise of political risk. Political risk happens when politicians control a much broader swath of the economy. Before the crisis, government actions directly affected about 40% of the aero industry (the defense part, plus government procurement of civil helicopters and jets). I can’t tell you what that number is today, but it’s well over 65%. Political risk, unlike market risk or macroeconomic risk, is much less forecastable or quantifiable. Imagine, for example, if TARP had been cancelled due to political whim (perhaps due to a greater Tea Party presence in the US Congress). You’d have significant trouble in the jet finance business, and there would have been no way to see it coming. (For a superb review of the rise of political risk, see James Surowiecki’s May 24th New Yorker column.)

EADS today is the best example of an aerospace company exposed to massive political risk. The A400M contract and A350 XWB development funding, both crucial to the company’s future, depend on politician’s whims, not on market fundamentals. But thanks to the factors listed above all aero companies today have an unaccustomed level of political risk too.

The second risk is that today, we really are all in. Governments can only do this once. Worldwide government action averted financial collapse and prevented any kind of jetliner downturn. But if this European crisis spreads, or if there’s any kind of double-dip recession for whatever reason, there’s not much that governments can do. As the Economist put it, “the scale of sovereign debts has left governments with less room to counter any new downturn; indeed, many of them are being forced into austerity” (May 27). Or, as Tom Friedman put it, we’re driving down a dangerous road and we’ve already used our spare tire (New York Times, May 23).

Even on the defense side, the growth in government spending will end. Earlier this month SecDef Robert Gates wisely cautioned that defense spending would be squeezed moving forward, and that the industry needs to live with flat procurement budgets. In Europe, we could see a more serious defense crunch that affects even performing programs like Eurofighter.

It’s been two years since that Farnborough car ride. If in two months I find myself with my colleagues reading headlines as dire as July 2008’s, then I fear the worst. Governments are now playing poker with an empty hand. It may seem as though the public sector has prevailed over free markets, but markets have a way of asserting their primacy, and hell hath no fury like a business cycle scorned. A double-dip recession would ensure that the jetliner business pays an overdue debt with interest. That means a serious production fall that’s even worse than the typical 30% cut.

But to conclude on an optimistic note, this dire scenario certainly isn’t our forecast. Right now, the US and most developing countries are doing fine. Our baseline forecast scenario calls for a sustainable industry plateau, with organic demand picking up as government spending ramps down. From that vantage point, this month’s WMCAB updates include the Regional Aircraft Overview, and updates of the 737/P-8, Hawk, T-45, E-2, P-3, and T-6/PC-9/21 reports. Have a great month.

Yours, ‘Til Farnborough Gets Moved Back To September (or to Scapa Flow),
Richard Aboulafia

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