Premium #308: Looking Ahead to 2017

As we approach the end of the year, it is time to look ahead to the new year, and what we will likely see next year. Our fearless forecast follows: Economic Growth Our industry is driven by economic growth, which translates into traffic growth and the need for commercial aircraft, just as corporate profits correlate with business aircraft. The problem in forecasting the economy is the unpredictability of political events. In 2016, we saw Brexit, the election of Donald Trump, and the defeat of Matteo Renzi in Italy. Who knows what's coming in France? For 2017, a major issue is whether we will see populist movements causing a further break-up of the EU. Should Italy, the third largest economy in the EU leave, joining the UK, an inexorable break-up of a single Europe will then have critical mass. Our expectation, however, is that irrespective of political sovereignty, free trade will continue throughout the Eurozone, and that the impacts on Airbus and other EU entities will be minimal. We don't expect protectionism from either London or Rome with respect to the rest of Europe. Donald Trump has indicated that he plans to be unpredictable, but expects to re-negotiate free trade deals, including NAFTA and likely not join the TPP. We expect him to keep his word, and are not certain what he will do, particularly with China. The call with the President of the Republic of China in Taiwan indicates a potential policy shift and a tougher stance. The jury is out on that topic. With respect to jobs, Trump has used the bully pulpit to stop job moves by Ford and Carrier, but has also enabled the free market to attract a $50 billion investment from Japan’s SoftBank in the US economy. Will there be tariffs or free trade? A Trump administration could move to match the 15% VAT placed on US goods in Europe with a similar penalty here, in order to correct a trade imbalance. This may result in some supply chain adjustments as economics change. Trump has also indicated a willingness to take on the corporate establishment, as indicated by his attacks on the Air Force One contract with Boeing and the F35 at Lockheed-Martin, calling the price-tags excessive. The question is whether this attitude will be picked-up by the Pentagon and other agencies, and if wasteful federal spending can be brought under control. Many have tried, but the government trend that has inclined to expansion its size and influence will be difficult to break. The impact of a Trump administration may turn out to be a modest jump in domestic GDP. As we are in the midst of a recovery from the “great recession,” economic growth of 2.6%-3% in his first year would not be unreasonable, but that would mean a number of things have to continue to move in the right direction. So far, so good, and inauguration remains a month away. Interest rates will impact aircraft finance, and we expect the Fed to modestly raise rates in 2017, perhaps by 25 to 50 basis points, after evaluating the impact of the already announced 25 basis point increase. We view multiple increases as likely. China remains a growth engine, and we expect air travel demand in the developing world to exceed that of the developed countries in Europe and North American by 2-3%. Traffic growth in the US and Europe will be low, in the 3-4% range, while traffic growth in China, Southeast and South Asia will be in the 5.5-7% range. China will continue to become a more important player in aviation finance, and we expect the Chinese to acquire AWAS, the aircraft leasing firm that will come onto the market shortly. Commercial Aircraft We expect to see potential derivative models launched in 2017, but not an all-new aircraft. Boeing will likely launch the 737MAX10 to combat the A321neo that is outselling the 737MAX9 by a 5:1 margin. We’re not optimistic about its ability to overtake the A321neo, which has firmly established itself as the 757 replacement. Will the -10 be a stretch too far? In the wide-body sector, we expect two new derivatives to be launched, the 777-10 and the A350-2000. Each will be a larger version of their super twins, and carry as many passengers as the 747-400s they will likely replace. Both variants have been offered to Singapore Airlines, and their decision will likely launch the first of the two variants. But other carriers are likely to show interest, and these VLAs will likely be 747-400 replacements for traffic dense markets. What will be their impact on the A380? It will definitely add uncertainty. The long term impact for Emirates is clear. Orders for new aircraft will likely remain weak, as the industry is utilizing older aircraft during a period of low fuel prices. We’ve seen an increase in the percentage of the fleet that is 15 years and older grow from 21% in 2013 to 24.5% in 2016. Because airlines invested in maintenance to bring back or continue to operate these older aircraft, we would expect them to remain in the fleet for one additional maintenance cycle, typically about 3-5 years depending on utilization. At the point, the economics of a major overhaul versus a new aircraft will be re-evaluated at the then current fuel prices and the trade-off between capital costs and operating costs re-evaluated. Fuel prices may rise slightly in 2017, but we believe the capacity provided in the US shale industry could quickly return as prices rise, putting a cap on pricing at about $50 per barrel. Moreover, we expect OPEC members to cheat. This will continue to benefit older aircraft. OPEC’s recent 1% price cut can easily be met through increased domestic production in the US to keep fuel prices low. As fuel prices are a key economic driver, we expect the Trump administration to be pro-active in this regard. The Supply Chain We’ve seen production disruptions resulting from the supply chain at several aircraft and engine manufacturers in 2016, with the hope that 2017 can bring aircraft deliveries back on schedule. Airbus has been the hardest hit, with delays on A350 from Zodiac and delays on A320neo from Pratt & Whitney. Last week we observed P&W and LEAP scheduled A320neos without engines parked in Toulouse. Delays should be reduced in 2017, but reflect the difficult that the industry is facing, as it will need to deliver the equivalent production of the last 30 years over the next decade. Keeping up with that increase requires capital investment by suppliers, some of whom are reluctant to do so without guaranteed program volumes from the OEMs, especially when they are being squeezed on margins. As one executive recently told us, “We all shop at the same stores” in referring to the supply chain, "and if a key supplier to multiple programs has delays, the entire industry can be impacted. All it takes is one missing part out of millions to ground an aircraft." We project the current difficulties with the supply chain will remain with us for the first three quarters of the year, but ease before 2018. Engines With new-technology narrow-body engines now hitting the market, the focus for engine manufacturers is execution on what can only be described as aggressive production schedules. Pratt & Whitney faces 13 new model introductions from five customers on four continents from 2015-2020. GE faces a huge backlog for the CFM LEAP, with roughly half the A320neo orders and the entire 737MAX backlog. Ramping up to record production levels will be a major challenge. With new wide-body engines from GE and Rolls-Royce for 787, 777, A350 and A330neo programs in place, the focus is also on execution, but at much lower numbers. We don’t expect any major engine program announcements in 2017 as the industry focuses on execution. Note the A330neo is now running six weeks late, apparently because of Rolls-Royce. The same company is likely to see some hits from its engines powering the Emirates A380 fleet. Rolls-Royce is a company we will be watching carefully in 2017. On the turboprop side, GE’s new ATP will utilize advanced technology, including building about 1/3rd of the engine using additive manufacturing, to compete with the dominant player, Pratt & Whitney Canada and their PT6. It appears the ATP will be the first major application of additive manufacturing for a substantial portion of the engine, as today only a few additive parts are featured in the GTF and LEAP. This represents a manufacturing technology change for the industry, but it will require speeding up the relatively slow additive manufacturing processes to realize truly cost-effective production. How quickly that happens will determine the pacing of additive technology in the industry, and GE appears to be strategically pushing that frontier. Will they have a breakthrough in 2017? The jury remains out. Business Aircraft The business aircraft market has been moribund since the beginning of the great recession, when a cycle of significant growth was snapped. We expect 2017 to be similar to 2016 in business aircraft, a relatively flat year. The introduction of the Cirrus Vision jet may substantially increase the number of deliveries in the very light jet sector in 2017, but the remaining segments of the market appear to be flat in our projections. We’ve seen hockey stick forecasts of a turnaround in the business aircraft market each year since 2011 that have not materialized. We simply don’t foresee a major turnaround in 2017. The Supply-Demand Balance In our view, today’s production rates for narrow-body aircraft appear to be in balance with the market, but we see risks in raising them substantially. We do not believe that Airbus and Boeing can each produce 60 narrow-body aircraft per month over the longer term when Bombardier, Embraer, COMAC and Irkut all join the market with their new models. The narrow-body market has a substantial backlog, and new major orders are unlikely until much of the backlog is worked off. We project fewer narrow-body orders in 2017. For wide-bodies, other than demand for the new technology 787-9 and A350-900, we see values and demand remaining flat in 2017. Several airlines have deferred wide-body orders, and others, like Turkish, will sub-lease aircraft that they will take delivery of in 2017. Demand growth is being accommodated in part by not retiring older aircraft, and each one remaining in the fleet typically translates to an aircraft that will be deferred. We’re also not optimistic about wide-body demand in 2017. We expect the book to bill ratios to fall under 1 for the commercial aircraft segment in 2017. The Bottom Line The political situation is a bit unpredictable, and the market situation very much a “status quo” for 2017 in our forecasts. Working off a record backlog has the focus of the OEMs, and delivering on promises is the key driver for 2017. We expect a relatively flat year, and solid, but not spectacular performance by the airframe and engine OEMs. 2017 will be the year of execution.

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