Aircraft assets still offer a good inflation hedge for lessors but nowhere near as good as in decades gone by, argues a major lessor's chief.
"Any hard asset will give you an inflation hedge, but I don't think the inflation hedge with aircraft will be as great as it has been in previous cycles," Avolon chief executive Domhnal Slattery tells Flightglobal. "In the '70s and '80s, it was a super hedge; this time around, it will be an acceptable hedge."
Aircraft have historically offered hedging against both the dollar and inflation but – if and when inflation does return – the level of correlation between the two "won't be as high due to production efficiencies", says Slattery.
This is true not just with aircraft but any asset in the world, he believes.
"When you go back to the 1980s, you had aircraft values inflating at five, six and seven percent a year, which was twice the depreciation rate. For the last eight to 10 years, it has been in the one-and-a-half to two percent range," he says.
If inflation were to return "at a global level", this figure could climb to 2.5-3% maximum, he adds.
But a lack of inflation is currently causing concern. Arguably, it is the reason that major central banks including the US Federal Reserve have put interest-rate hikes on hold.
Deflation worries in the eurozone prompted the European Central Bank to start a quantitative easing programme in January, to push inflation closer to its 2% target.
While Slattery believes global deflation is a "real risk", he says the "global emerging middle class" helps to put the real economy into perspective.
"There is a balancing aspect, and this is what we can't lose sight of, because this is the backbone of aviation – the emerging middle class," he says. "You have 1.2 billion people coming into the global middle class – as defined by the OECD – between now and 2025. That is a 60% increase, and the vast majority of these people have never been on an aircraft."
This, he says, is a "transformational demographic wave that the world has never seen before and, as long as that trend prevails, the issues we see from time to time, whether it is excess supply of this, or interest rates of that, they just become rounding errors in the scheme of things".
Though talks of an interest-rate increase by central banks have cooled due to worries in China and the emerging markets, Slattery believes a hike is a near-term prospect.
The interest-rate cycle generally reflects what is going on with global GDP but swap rates have recently dropped 10%, he says.
"I personally think this is a near-term blip. I think rates are going to go up and I think they will go pretty quickly."
He points to the trajectory of rising interest rates in the last 20-40 years. "They go up at a fair pace when they start rising, and airlines and lessors that are not hedged for it or planning for it will get into trouble."
If the US Federal Reserve does not act soon, he says, "eventually they will be left with nothing they can do in two to three years' time".
When Slattery started in the aviation leasing industry in 1989, six-month Libor was at 8%. Now, it is 50 bps.
"We’ve got to get back into a more normalised world. There are benefits from a more normalised world."
In terms of the aviation cycle, he sees the market as "some distance from being at a cyclical peak" owing to the events of the past eight years.
"If we had tracked to a normal cyclical trajectory, we should have been at a peak last year from the down-cycle in 2007-08, but because of the series of crises, these have delayed the kick-start to any cyclical peak."
Though the book-to-build ratio, airline profitability, utilisation levels, load factors and the absolute cost of fuel all affect the overall aviation cycle, he cites GDP as the predominant driver. "The rest filter into it, but GDP is the main factor."
He adds: "Airlines, particularly in the USA, are tipped to make more money next year than this year and I suspect that is the case because they have pricing power. I think we are some time away from when the unions will start sucking out the juice from the majors in terms of their labour arrangements, so there is definitely several years of the good times."
Airline profitability and the prevailing fuel input prices are also big drivers of future profits, "and when the airlines are making more profits, they are generally in growth mode, and when they are in growth mode, they want more aircraft", says Slattery.
While he admits "there is probably excess capacity, predominately in widebodies, in Southeast Asia", he says "the market is working its way through the challenge".
He adds: "There is intense airline competition in places such as Malaysia and Indonesia, etc. But at the same time, there is still massive growth. We are not seeing anything that makes us nervous or fundamentally concerned. Of course, there are parts of the world, as there are every quarter of every year, where you have stress-points for one reason or another."
Source: Cirium Dashboard
