Inflation and The Upside Case for Aircraft Investors

April 2008 ISTAT Jetrader Publication Submission

The past four decades in the U.S. are looking uncannily similar to each of the four decades which preceded them from economic, social and political perspectives.  In the 1930’s and 1970’s the U.S. experienced depression/recession and maximum aversion to risk.  The 1940’s and 1980’s marked turning points as the U.S. and its allies claimed victories over the “hot” and “cold” wars.  The ensuing psychology was fueled in the 1950’s and 1990’s by economic expansion against a backdrop of global peace.  These periods also saw rising levels of “consumerism” and increasing financial leverage across most sectors of the economy.  The 1960’s and 2000’s then marked turning points in psychology and economic momentum, with the Cuban Missile Crisis and Vietnam conflict then, and the 9/11 attacks and Iraq conflict more recently, each indicating a less safe world.  Exhibit 1 illustrates the similarities in U.S. equity market performance during these prior two 40-year periods (or super-cycles).

exhibit 1 skyworks chart

Exhibit 1:  Dow Jones Industrial Average over 40-Year Cycles


In light of the foregoing observations, the distress seen in the financial markets since mid-2007 can be viewed as a “popping” of the risk tolerance bubble that originated in the 1980’s.  This was fueled by a psychological environment that supported unrealistic extrapolations of economic momentum and rising asset values by market participants.  The ensuing backlash has swung the appetite for risk in the opposite direction, making it reasonably probable that history will continue to repeat its 40-year pattern with the U.S. entering a period of slower economic growth last seen in the 1970’s.  As discussed below, that period was also marked by accelerating inflation which represents a positive dynamic for aircraft as an investment class. 

The Resurgence of Inflation and Implications for Aircraft Investors
In a previous Jetrader article (February 2007), we argued that the inflexibility of the aircraft supply chain makes demand for air travel (and, by implication, the global economy) a key determinant of shorter-term cycles in aircraft valuations.  Record energy prices are now an added layer of complexity to the aircraft valuation puzzle, as sustained high fuel prices (crude was hovering at nearly $120/bbl at the time this article was written), all else equal, are likely to support demand for newer efficient aircraft at the expense of certain older types.  Witness the recent actions of most of the U.S. Majors to remove certain older aircraft from their operations.  However, if fuel prices continue to rise further, then carriers could begin the wholesale downsizing of their fleets, perhaps in tandem with consolidation activity, which would result in a net decrease in aircraft demand during an adjustment period. 

While economic activity and energy prices are key drivers of aircraft valuation cycles, the role of inflation should also be considered by aircraft investors and is perhaps of greater long-term importance.  The residual value of an aircraft is a function of the “real” future asset value and the rate of inflation over the given period.  Falling inflation rates therefore depress nominal aircraft residual values below anticipated levels.  The losses suffered by investors in U.S. leveraged leases that unwound during the industry’s last restructuring cycle were undoubtedly aggravated by the prior era’s trend of decelerating inflation.  Accelerating inflation, on the other hand, represents a positive dynamic for aircraft as an investment class versus traditional financial assets such as equities and bonds. 

If economic patterns continue to repeat in the aforementioned manner then we are likely to see a sustained period of inflationary pressure.  Exhibit 2 illustrates inflation before and after its prior inflection point which occurred approximately 40 years ago, and the ensuing 40-year cycle starting in 1990, leading to the observation that a continuation of the 40-year pattern forebodes significantly rising inflation.

Exhibit 2:  Inflation Trend over 40-Year Cycles


A review of today’s economic environment serves up a similar outlook for inflation.  Outsourcing of production to lower cost producing nations was one of the key forces behind decelerating inflation.  However, this trend has matured and many of the countries that have become key producers of goods for the U.S. and other large developed nations are themselves experiencing accelerating inflation, in certain cases approaching or exceeding double digits; the currencies of certain of these producers are also appreciating relative to the U.S. Dollar thereby exacerbating this inflationary impact.  These forces as well as increased risk premiums on capital, nominal or negative real U.S. interest rates, and increasing demand for the world’s resources from rapidly growing developing nations, collectively indicate that inflation is likely to be of far greater influence in future years than it has been in the recent past.  Furthermore, the assumption that the U.S. Federal Reserve can use its monetary levels to readily curb inflation is no longer self-evident as the U.S. and many other developed economies are no longer the primary producers of their consumed goods or the primary drivers behind much of the growth in net demand for the world’s resources. 

Conclusion
In the long-term, inflation is a key driver of aircraft residual outcomes, even though it has been less topical in recent years.  The observation of a 40-year super-cycle in which inflation was at a key inflection point approximately 40 years ago, and a multitude of other observable factors, indicate that inflation will play a more forceful role in the future.  Such an outcome should make aircraft an attractive long-term asset class versus traditional financial assets.