CTAIRA analyst Chris Tarry considers the impact of economic growth projections on airline capacity plans for next year

As attention turns to summer 2016 schedules and the slot co-ordination process for the season, it is timely to examine the likely operating environment and how economic expectations are changing, as well as the likely implications.

In recent results we have seen a number of airlines – particularly the US majors – reduce their already modest capacity plans to reflect actual and expected economic developments. These include a general response to reduced forecasts for 2015 GDP growth compared with when capacity plans were being decided – and more specific reactions, for example in the case of United Airlines, with further reductions in the US “energy markets”.

This column often focuses on the importance of traffic value rather than volume alone, and how less capacity will generally result in more in terms of the financial outcome. This was a point underlined by United’s chairman as the most recent results were released, when he said that management would “continue to take the necessary capacity and network decisions to deliver value to our shareholders”.

Moving a little further north we have also seen the WestJet chief executive Gregg Saretsky appear to question the link between GDP and traffic, while analysts seem to take the view that the airline is adding too much capacity. It is differences in view that make a market for any company’s shares, but it must be recognised that the supposed GDP-traffic multiplier does not have a constant value along the fare curve, and that for any given rate of GDP growth an airline offering lower fares will demonstrate a higher multiplier.

The extent to which this is “structurally different” and sustainable depends first, of course, on whether such fares are profitable – and secondly on how much further they might fall, which in turn will be determined by the airline’s cost base, even allowing for adjustment lags. A race to the bottom that fails to result in a structural advantage is essentially self-inflicted damage.

The reality is that there is a high-level link between GDP and underlying travel demand (even though it is a revealed relationship). More accurately GDP should be seen as a proxy for a range of other economic factors that should feature in traffic forecasting models. There is also a need also to get behind the high-level figures to examine local circumstances and look at longer-term trends. A myopic view always has the potential to damage the business by missing out on something.

Twelve months ago, when the capacity decisions for the current summer season were being considered, the consensus forecast for world GDP growth was in the order of 2.8% for 2014 and 3.3% for 2015. In the event the outcome for 2014 was in line with the forecast but, as we move through 2015, forecasts have been cut back and the current expectation is for this year to have an outcome closer to 2.7%. This reflects the effect of a number of movements in different directions at a country level compared with the forecasts made a year ago.

For these purposes we have taken the forecasts from PwC’s Global Economy Watch (July 2015 and August 2014 as the comparator), which show no change for the eurozone (1.5% versus 1.4%) and an increase for India (7.5% versus 6.6%). Among those where the current forecast is now lower than a year ago are the USA (2.3% versus 3.0%), China (7.0% versus 7.3%), Russia (-5.0% versus 1.5%) and Brazil (-0.9% versus 2.5%). However, since these forecasts were released in July there have been a number of purchasing manager surveys; those most recently published by Markit and JP Morgan “signal a rate of global growth of approximately 2% pa” and suggest the greatest impact will be felt in some of the emerging markets.

Clearly there is downside risk to some of the key economies for the rest of 2015. It is is inevitable that economic forecasts for 2016 will also be reduced from current levels, where the expectation was that there would be a bounce-back to the rates of growth that were previously forecast. However, given the role that experience and behaviour play in conditioning expectations the risk is that although the current forecasts will be cut, the resulting outcomes may be over-pessimistic in some cases – which will tend to reinforce associated uncertainty.

What, then, of the changes that have taken place in airline capacity? For summer 2015, the schedules from DIIO SRS Analyser suggest that overall there will be 3.4% more flights, 5.7% more seats and 6.6% more ASKs – with larger aircraft flying longer distances. For the forthcoming winter season the trend appears to continue with 4.8% more flights, 5.4% more seats and 6.5% more ASKs scheduled. Whilst the summer 2015 outcome appears “within limits” we would expect the actual outcome for winter to reflect slower and lower growth than indicated at present.

But there are two other factors to consider, which bring us back to where we started. It is the cost base of an airline and the fares it is able to profitably offer that will determine the apparent GDP multiplier. Recently fuel has fallen back to levels last seen at the start of the year, and this (depending on the speed at which the benefit flows through) enables fares to be more competitive if necessary. However, now is perhaps the time for airlines to retain as much of the benefit from lower fuel as they can and, given how economics work, adjust capacity rather than price to a weaker underlying demand environment.

As ever generalisations are dangerous, and for some airlines times of change and challenge we continue to be an opportunity.

We will not be alone in the next few months as we look closely at which GDP forecasts for the rest of 2015, and also for 2016 and beyond, might be changed – and by how much. Capacity announcements for summer 2016 will also be carefully examined in the context of an increasing recognition that less may indeed be more.

Source: Airline Business