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Equity Market Volatility Belies Strong Economic Fundamentals Clouding 2019 Prospects

As we close out 2018, it’s time to look ahead. What’s in store for 2019? Equity markets and global political conditions are volatile while the fundamentals of the U.S. economy remain strong. Market turbulence can be caused by a number of factors; the impacts of some we can forecast, the impacts of others are not fully knowable. Everyone has opinions. Here are RESIDCO’s insights from our own analysis.

Unemployment and Wage Rates

Last week, the U.S. Bureau of Labor Statistics reported the unemployment rate unchanged at 3.7% (for the third month in a row). That’s a low not seen since 1969. Low unemployment tightens labor markets which lead to wage increases. Full employment elevates consumer confidence and drives consumer spending.

But rising wages pressure inflation and the Federal Reserve’s expected response will be to continue to raise interest rates which will create a moderately more challenging business environment.

Domestic Growth

Also announced last week, U.S. shale production turned America into a net oil exporter for the first time in 75 years. Crude oil and jet fuel pricing are moderating. Trump’s Tax Cut and Jobs Act and deregulatory agenda have driven domestic growth above trend.

GDP has expanded by 3% over the past year and the Federal Open Market Committee expects it will continue to grow above trend in 2019. Over the past thirty years, the average growth in revenue passenger kilometers (“RPK”) has exceeded global GDP growth by about 1.7 times each year. Applying this history to recent International Monetary Fund economic forecasts implies expected global passenger growth of ‘around’ 6.3% for 2019. Despite market turbulence, the outlook for 2019 remains positive. Commercial aircraft manufacturer order books certainly support this optimism.

Bracing for Turbulence

Prior to every flight, a pilot checks the weather. Flight risk is mitigated by adjusting routes to avoid thunderstorms and icing. The FAA defines Clear Air Turbulence (“CAT”)’ as sudden, severe turbulence occurring in cloudless skies that causes violent buffeting of an aircraft. It’s a recognized problem that affects all flight operations and is especially troublesome because it is often encountered unexpectedly and frequently without visual clues to warn pilots of the hazard. The first step in avoidance of hazards? Establish access to the best available information for planning flight operations.

Similarly, when heading into economic turbulence consider your investment horizon, goals, and risk tolerance. Different aircraft portfolios react to turbulence in different ways. The solution is to develop a set of protocols that deal with uncontrollable events. An example: earlier this month the yield curve flattened, producing its first ‘inversion’ in more than a decade. History shows inversions have preceded all nine U.S. recessions since 1955 (with lag times from six months to two years). The year ahead won’t bring the end of the current cycle. There is time to dodge market turbulence, secure the cabin, and adopt defensive investment strategies.

Late cycle investing for current income and capital appreciation? Call RESIDCO.

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The Goal: Driving Up Asset Utilization

Past Challenges

Before Hunter Harrison, the prevailing view was more locomotives, more railcars, and more crews allow for the movement of more volume. But because track and yard capacity is finite, adding more equipment creates congestion and slows the system. While it is counterintuitive, reducing fleet size enables a road to move more volume by running fewer (longer) trains, faster. ‘Scheduled’ service results in better asset utilization and higher profits.

For example, CSX’s ‘operating ratio’ (its operating cost as a share of revenue, the industry’s leading benchmark for efficient operations) dropped to 58.7%, a third-quarter record, while third-quarter profit increased 106%.

CSX’s Revolution

The results CSX is delivering are pushing the remaining U.S. Class Ones to consider adopting similar strategies as North American railroad executives face investor pressure. By rigorously scheduling service and eliminating bottlenecks, ‘Precision Scheduled Railroading (“PSR”)’ transports the same or more freight with less capital in the form of railcars, locomotives, and classification yards. Classification yards are choke points that slow traffic.

After dropping out of Memphis State to work as a dispatcher in a rail switch tower, he said: “It was then I learned that how you arrange schedules and manage assets are the key.” In his eight months at CSX, Hunter Harrison converted no fewer than 7 of CSX’s 12 hump yards into ‘flat-switching’ (by a locomotive on yard tracks) facilities resulting in faster deliveries from origin to destination.

Hunter Harrison’s legacy? Root out schedule inefficiencies, minimize asynchronous traffic flows, reduce cost, and create opportunities for timely ‘scheduled’ delivery. Focusing on efficient network operations results in maximum use of existing equipment and ultimately will change how the industry invests.

A Locomotive Industry Shift

Union Pacific is moving to follow the same playbook. It has idled 625 locomotives, with plans for idling another 150 by the end of this year while removing 6,000 cars from its network with plans to cut an additional 10,000 railcars over the near term. Compare PSR to airline network operations. Aircraft fly on schedules with minimum time on the ground. The efficient use of aircraft results in less investment and improved yields. ‘Scheduling’ operations allows matching of staffing, asset levels, and work sequences accurately. CSX results demonstrate this.

As Class Ones effectively implement PSR, network and terminal velocities will improve. Improving service will grow market share, take traffic from the highway, and deliver enhanced financial results for both the Class Ones and shippers, thus enticing new private investment in rail assets.

The Goal? Right-sizing capacity while implementing efficient asset management techniques. The results? Timely deliveries, improved returns on invested capital, and satisfied customers. Rail equipment knowledge creates opportunities that unlock portfolio values in this environment. Interested? Call RESIDCO.

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