27/06/2016

What does Brexit mean for aviation investors?

What does Brexit mean for aviation investors?

As Winston Churchill once said, “Democracy is the worst form of government, except for all the others”.

The UK’s vote for Brexit is clearly part of a much wider argument - a signal of dissatisfaction, some have even said “an act of self-harm”, of polarisation between young vs old, rich vs poor, urban vs countryside, nationalist vs internationalist.  That analysis is best left to the macroeconomic experts, although astrologers and tea-leaf readers will also volunteer.  

For Ishka and its readers, what does Brexit mean for investors in aviation?

We have looked briefly at three key areas in aviation – the hardware (i.e. metal - airplanes, fleets and manufacturing) the software (passengers, traffic and the economy) and the operating environment (regulation and legislation, the means to deliver a safe system, and infrastructure).  All are clearly interlinked.

An excellent place to start is IATA’s non-‘knee-jerk’ analysis, ‘The Impact of ‘BREXIT’ on UK Air Transport’.  It was not formulated on the day, and clearly much was considered in advance.  For Ishka, probably the key take-away from this report is the suggestion that the number of UK air passengers could be 3%-5% lower than the ‘no Brexit’ baseline forecast, by 2020. 

This is anticipated to happen as a result of an expected downturn in economic activity (some suggest stagnation, even recession) and the fall in the sterling exchange rate.  IATA also note that the impact of Brexit is expected to be a permanent downward shift in the level of GDP, not a temporary impact that is recovered.  IATA referenced a wide range of GDP estimates including from HM Treasury, OECD, CBI and NEISR.

A weaker Sterling means air travel from the UK will become relatively more expensive – rising prices will dampen demand, although conversely overseas visitors would have greater spending power in the UK, which could lead to more inbound tourism.  UK outbound traffic in 2015 was twice that of inbound (53.9 million visits overseas compared to 26.2m visits to the UK).  The net effect is an anticipated drop in passenger traffic, relative to the forecast baseline, over the next three to four years.

How are the UK’s airlines positioned?  Without a fleet adjustment, such a forecast decline in passengers would lead to lower load factors and reduced revenues.  The recent drop in IAG’s share price reflects weaker trading in recent months, more so than the Brexit effect, so maybe the signals are already there. 

However the beauty of the easyJet and Ryanair operations is that they are truly European, they have no qualms in moving capacity around their networks in the European arena, to match capacity to demand and seek opportunities elsewhere as and when circumstances dictate.  We don’t foresee a material impact of Brexit on their long-term strategy or growth. The airlines that are more vulnerable are the UK based carriers that don’t have that wider network. However, they should have enough time to ‘right size’ their operations should traffic levels start to depart from expectations.

From a manufacturing perspective, initial thoughts turn to Airbus, Rolls Royce and a host of companies in the supply chain.  A weaker pound makes UK exports cheaper for foreign buyers, which is good news for companies like Rolls Royce, which has a large exposure to foreign exchange, especially to the US Dollar.  With the majority of its revenue and backlog emanating from outside the EU, Brexit is not likely to have a material impact on its day to day business.  Airbus’ exposure to the UK is a little more complicated.  Airbus has confirmed business as usual in the near term, and will work with the UK Government to minimise any impact on its current UK investments – however future investments in the UK will be under review.

When considering sector financing and infrastructure investment, the UK is not the only country in the world that is an investable proposition.  In a post-EU environment the UK will need to sharpen its fight for investment, not just against the rest of the world but against the EU too.   

So from the hardware and software perspective, yes we have had a shock, but shocks are typically short term and with hindsight will appear as only a blip on future charts.  Airlines have the time and flexibility to adjust to a change in traffic flows, if/when they materialise.

However, as far as airlines are concerned, there is still the operating environment, and this is where there may need to be a more significant re-alignment.   Europe has a Single Aviation Market, the European Common Aviation Area (ECAA) to which EU members plus Norway, Iceland and eight South-East European states, have access to and the freedom to operate routes within Europe, in accordance with EU aviation law.  

UK airlines and UK passengers will inevitably seek access to the Single Aviation Market, however the UK will presumably also seek policy freedom to set its own regulations.  To be part of the ECAA requires acceptance of EU law.  Bilateral agreements with the rest of the world will also need to be addressed.  How these scenarios play out will dictate the shape of the UK’s airline industry.  There are models in place, involving other countries such as Norway and its participation through the EEC, that could serve as a template for the UK.   The UK will negotiate for access to the EU markets, but Brexit means its ability to influence future EU policy will evaporate, including that of EASA, in terms of Airworthiness and Safety regulation.

The landscape will change, but time and preparation are some of the key tools available to the UK airlines and manufacturers as the extraction from the EU progresses.  The landing should therefore be a smooth one, not hard.  If UK aviation struggles, it will be issues larger than Brexit that will be responsible.

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