Executive Summary
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Today’s note steps back from company-specific issues. We’re going to look at the macroeconomic factors that affect our areas of interest.
The problem
Where do we start? It’s easy to forget, living in today’s non-stop news cycle, what we’re all been through.
For a unique period of history, a common experience united the world during
2020 – 2021, COVID-19 tore around the globe. Lacerating life as we knew it, its longer-term effects are only now surfacing. And right now, one of those effects is inflation. A phenomenon we all thought was consigned to semi-mythical history. Stories told by economists to frighten their children.
The background
The global macroeconomic environment we are experiencing in the latter stages of 2022 stems from the successive economic crises of the last two decades. The so-called Great Financial Crisis (GFC) of 2007/8 resulted in a period of supportive fiscal and monetary policies designed to help repair the damage caused by the recessionary forces of the GFC. This included low and, in some cases, negative, real and nominal interest rates and stimulative bond purchases by the main central banks. These purchases were made through a process known as quantitative Easing (QE).
These supportive policies were just beginning to be wound down, most notably in
the so-called ‘taper tantrum’ of 2013, when the markets reacted badly to the attempted reduction of QE by the Fed. We now find ourselves in an even worse situation, where the great moderation experiment is coming to a close, and no one really knows what the results will be.
Aerospace investment consequences
Aerospace is an industry with huge capital requirements. Capital costs.
Capital is needed to cover the huge costs of certification and development of aerospace projects.
And capital isn’t free. It has a variable cost. Since the GFC, capital has been cheap, in some cases essentially free. That variability of cost is coming as a shock to some, including it seems to ‘Mr Market’, as evidenced by the wild swings with the world’s equity and fixed income indexes.
Right now, capital is on a path of increasing cost. There are various reasons for this, all of which will affect investment performance in the short and medium term. At a simplistic level, inflation raises the cost of labour, commodities and services. So the basic costs of development and manufacturing will go up.
Aerospace is particularly vulnerable to inflationary cost spirals. Its critical staff tend to be highly educated, specialist, and therefore expensive. It is also an energy-intensive industry, so higher input costs always have a significant effect. The important corollary to that is the eternal drive towards greater efficiencies that higher energy costs provide.
It is also possible that the inflationary effects on energy prices experienced since the onset of the conflict in Ukraine could act as an accelerator for the green energy transition alongside greater and decentralised clean energy production.
Investment winners
In the near term, companies with solid and predictable cash flows and cost control features will succeed, while others exposed to variable costs and unstable cash flows will not.
So, in the airline industry, well-established lower-cost companies, such as Ryanair (RYA:ID) in Europe and Southwest (LUV) or Delta (DAL) in the US, should win. This, of course, depends on their maintaining cost discipline, particularly in FX, labour and fuel.
Now is not the time to start an airline. There will be significant scale disadvantages, and costs are likely to become untethered compared to larger competitors.
Some legacy carriers struggled to make profits during periods of low capital costs, making it difficult to envisage them succeeding when capital is expensive.
Additionally, the major original equipment manufacturers (OEMs) are exposed to inflationary cost overruns with their significant supply chains.
In both cases, success during this period of increased costs will boil down to how many companies can control cost spirals from labour and sub-contractors. Indeed, organised labour relations may play a role for the first time in generations. In the US majors, there has already been upward pressure on terms and conditions. This has been less prevalent in Europe, largely because of the shadow of the overhang of COVID-19 effects on the industry there.
This brings us to a salient point. Not all inflation is the same. It is becoming increasingly clear that inflationary forces in EMEA and the US have diverged and are in- creasing to diverge.
In EMEA, supply primarily drives the inflation story, supply pressures forced onto economies weakened by COVID-19 and now by the Ukraine war.
In the US, COVID-19 had quite different economic effects, largely because of the direct fiscal stimulus put into place. The COVID-19 recession was deep, sharp, and very short. Indeed, the lasting effect of COVID-19 was a shortage of people willing to work, whereas, in EMEA, the recession was longer and arguably, it didn’t resolve itself into meaningful economic growth.
Traditional economic orthodoxy holds that when inflation rises to an uncomfortable level, in most cases significantly beyond 2%, central banks will raise interest rates to “cool” the economy.
Except for Japan, this is where all major central banks are in agreement. From a period of historically low-interest rates and, therefore, abundant and “cheap” capital, the world’s economies are now “tightening” their monetary support. This makes capital more expensive.
The main issue for aerospace investments is that this economic theory and practice is being carried out on an uneven playing field. So while the methods from central banks are the same, the results are not.
The US has an economy that is overheating and experiencing an excess of demand, driving prices up. EMEA is an area with a generally weak supply of essentials and is bordering and, in some cases entering a recession.
Investment losers
Considering the above, it is possible to identify particular areas of weakness within aerospace. In the airline industry, both the airlines themselves and their supporting companies are likely to enter a period of stagflation. This phenomenon of low growth and high inflation brings economic weakness across the board.
As mentioned above, poor cost control and lower demand caused by a recession will affect weaker airlines and weaker ancillary companies. There is clearly a period of reactionary travel post-lockdown, but it will be difficult to service once discretionary spending reduces.
Advanced Aerospace and new technology
Unlike during the French Revolution, for aerospace projects under development, it won’t be “the best of times and the worst of times”. It will be the worst of times and the less worse.
This may seem overly pessimistic, but to paraphrase Warren Buffett, we should drink champagne when others are panicking. Or, in our case, we should observe as market forces remove less credible, weaker aerospace prospects from the playing field. This will allow us to identify companies and technologies with a more reasonable chance of success.
Without these periods of creative destruction, excess capital will chase the next shiny new thing. FOMO, or the fear of missing out, becomes an overriding human condition that supports ideas and companies that suck resources away from those entities that deserve greater attention and support.
Recently, there have been examples of this within the eVTOL industry. Kittyhawk, a start-up funded by Google’s co-founder Larry Page, has recently ceased operations. Despite considerable financial support from Boeing through a joint venture branded WISK, Kittyhawk never really moved beyond the single/dual seater with a flight endurance of about 20 mins. Whilst this is an achievement in itself, for commercial operations to be financially viable, vehicle endurance will need to be significantly greater.
At Ancieo, we have repeatedly stated that aerospace development is both hard and expensive. At the risk of paraphrasing Buffett again, when the capital tide goes out, we see that projects and start-ups are built on weak foundations.
Recently, we published a research note summarising one of the stronger prospects in the eVTOL industry, JOBY. Readers can acquaint themselves with the points raised, and we will soon examine some hazards and opportunities in the greater eVTOL universe. At Ancieo, we believe there will be parallel openings with supporting technologies in energy storage, communications and edge computing, among others.
Sensor technology and automation are areas of particular interest in mobility industries. Keep a ready eye for strong candidates, as these have high margins and economic moats that will hold them in good stead during the economic lows we are experiencing.
Both sectors and those in the edge/fog/cloud computing industries have enormous crossover potential.
Conclusion
There’s no sugarcoating that we’re in a period of economic risk and volatility. But the truth is, this helps those who are prepared to do the hard work that meaningful research demands.
The era of easy money allowed for “spaghetti” investment allocation. Investors could throw their pasta (money) at the wall to see what sticks.
Indeed, some within the venture capital industry believed that with abundant liquidity, they could essentially follow this strategy. If X amount of start-ups failed, that’s OK because Y will succeed at such a scale to pay for the pan of pasta thrown at the wall.
Trouble is, the pasta is much more expensive if it exists at all. There is no alternative for hard work and research.