With economies ‘locked down’ and travel restricted, the pandemic has disrupted U.S. industrial production and impacted derived domestic rail freight traffic negatively. The Federal Reserve reported manufacturing output fell by 13.7% in April, its largest monthly decline dating back to 1919. Record declines in spending and employment are creating State budget disasters. Furloughs caused by the lockdowns are creating current economic disasters for furloughed workers and their families. The American Association of Railroad’s (“AAR”) April reports U.S. rail traffic falling 25.2% and intermodal falling 17.2%. April’s originated carloads averaged 196,107 per week, the lowest weekly average for any month in more than three decades.
All major car loading commodity groups fell including coal, autos, steel, lumber, chemicals, scrap, petroleum products, sand, and food products. Autos and auto parts traffic disappeared in April because the auto industry shut down for the month. Petroleum products and frac sand fell due to the price collapse in the crude oil markets.
Earlier this year, China pledged to increase purchases of American farm, energy, and manufactured goods by at least $200 billion over two years ($12.5 billion over a 2017 base of $24 billion in 2020, and $19.5 billion above that base in 2021). China’s farm imports from the U.S. of $5.05 billion in the first quarter were up 110% from last year (up 72% in January, down 27% in February, and up 37% in March). Soybeans were up 210% from last year, pork up 640% from last year, and cotton up 43.5%.
To hit trade-deal targets U.S. farm exports to China will need to double this year. But China’s First Quarter GDP contracted 6.8%, its first drop in the twenty-eight years since Beijing began reporting quarterly gross domestic product in 1992, and a further contraction is expected in Q2. China’s follow through on the trade deal may be challenged by a U.S./China strategic confrontation resulting from Beijing’s lack of transparency in its handling of the outbreak of the coronavirus.
Regardless, China is the largest manufacturer in the world and the largest commodity consumer; 1.1 Billion more people live in China than in the U.S., and China’s working-age population is 900 million (geographically China is 98% the size of the U.S.). The Eurozone economies (as a whole) contracted 14.2% in the first quarter (the U.S. 4.8%). To match the U.S. population of 328 million requires combining the populations of Germany, France, the United Kingdom, Italy, Netherlands, Belgium, the Czech Republic, Austria, and Switzerland. The world’s globally integrated manufacturing networks remain in disarray. Most expect Q2 to be worse than Q1. This is not a normal contraction.
But with 25% of the 1.672 million North American Rail fleet in storage, the disruption creates the opportunity to deploy capital as the economy reopens. Americans will return to work and rail transportation will remain economically compelling. For careful, conservative, common sense, and competent solutions, call RESIDCO.
The past aviation super cycle was driven by growing demand from Asia’s emerging middle class (China) as well as the expansion of no-frills carriers. With much of the world now subject to air travel restrictions more than two-thirds of the world’s passenger aircraft are parked. The reality is that most of these aircraft will be parked for the remainder of 2020.
Boeing expects air traffic may not return to 2019 levels for two or three years (David Calhoun at a recent investor presentation announced, “we will be a smaller company for a while.”) Airbus, the European plane maker, is cutting jetliner production initially by a third, and embarking on a plan to ‘right-size’ its business. In a ‘Best Case’ scenario traffic will return to ‘normal’ mid-2021. While both are optimistic air traffic will eventually revert to its long-term growth path, the reality is they just do not know when.
‘Lockdowns’ are causing businesses to lay off workers where face-to-face interaction is unavoidable. Over the past six weeks, the Labor Department’s initial jobless claims have totaled over 30 Million (unemployment is forecast at 20%, the highest since it reached 25% during the Great Depression). With the U.S. economy shrinking at a seasonally adjusted annual rate of 4.8% in the First Quarter and a further decline expected in the Second Quarter, we are entering a recession.
Conservative ‘Worst Case’ estimates expect a ‘U’ shaped recovery – two to three years for air traffic to return to trend line growth; Domestic narrow body smaller aircraft traffic first, International traffic later. Airline executives are now leaning toward smaller aircraft that can be more easily filled in a time of depressed demand. Delta is keeping all 31 of its fleet of A220s flying, despite grounding more than half of its fleet (it has firm orders for an additional 64). Boeing terminated discussions with Embraer SA (which produces a rival to the A220) and will now rely on returning its 737MAX to service. Will cabins be configured to allow social distancing while we wait for herd immunity, require everyone to wear a face mask, take temperatures at the gate, or a vaccine appears? Ultimately, how quickly global traffic recovers will depend on how well the current outbreak is contained and how the global community chooses to work together to limit future outbreaks.
The trend toward younger fleets started after 9/11. Markets were surprised when many U.S. carriers decided not to bring back the 737 Classic. Similarly, the COVID crisis is creating a dynamic that is forcing Carriers to ‘right-size’ existing fleets, retaining newer models, taking delivery of aircraft in the current production inventory (e.g. Boeing’s 737MAX — with financing supplied by the added liquidity the Fed is providing), and retiring older units[1]. Air travel is not going away. Look closely, the pandemic is likely to create asset investment opportunities. But, be prepared for a ‘choppy sluggish’ recovery even after the virus is contained. To navigate to tomorrow’s fleet environment, call RESIDCO.
[1] With oil’s collapse, economics (and load factors) will ultimately decide whether existing equipment remains attractive.
Freight Demand Sustains Transportation Equipment Investment
Air cargo represents less than one percent of global trade by tonnage but amounts to $6 trillion worth of goods moved every year – more than 36 percent of global trade by value. Globally, half of that airfreight cargo has been carried on passenger jets rather than dedicated freighters. The rapid shutdown of passenger flights has eliminated passenger jet freight capacity, and air freight rates have responded, increasing significantly.
With the cascading passenger flight cancellations (and flight restrictions), air carriers are moving idle passenger planes to freight in high-demand routes, taking advantage of the very high air cargo market rates at a time when fuel prices have plummeted (American Airlines Group Inc. is flying its first scheduled cargo service since 1984 between Dallas and Frankfurt). As Asian manufacturing capacity comes back online, moving goods to the U.S. will further increase demand for airfreight. Equipment maker, John Deere & Co., is budgeting an extra $40 million in expedited freight cost for the second quarter to help ensure parts from Chinese suppliers can reach its facilities in Moline, Illinois.
Markets are telegraphing their uncertainty over how long the coronavirus will impact the domestic consumer activity which has driven our recent eleven-year bull market run. The sell-off that’s occurring is being amplified by a constant media blitz of event cancellations, corporate travel bans, ‘shelter in place,’ school closings, and election-year ‘coronavirus politics’. To stop the pandemic, we are forcing a recession. Near-term, the impact will reduce second-quarter economic growth. However, the politics of the fall election (and a $2 Trillion Stimulus package) will lead to a rebound in the second half.
While commercial passenger air travel has been turned on its head, U.S. rail freight continues to move the essential goods we need to survive. The slowing of the global and U.S. economies will delay domestic rail traffic improvement.
But, as the summer appears, and the virus abates, domestic manufacturers and retailers will need to play inventory catch-up. Companies will face such a need to restock there will be the potential for a significant freight traffic recovery in the second half of this year. Longer-term, rail equipment demand uncertainty has been created due to the industry’s adoption of precision scheduled railroading (“PSR”). PSR (and trade) are driving the market dynamics, impacting rail equipment values and lease rates.
Rail traffic (excluding coal and grain) is down year over year (still up from January lows). First-quarter container volumes through the Port of Los Angeles, the largest U.S. gateway for inbound seaborne container shipments from China, are expected to be down 15% year-over-year. Spring flooding will impact traffic along the Mississippi. Oil’s slide will negatively impact the demand for crude oil tank cars and the frac sand cars that serve the shale oil industry.
Air and Rail equipment values and lease rates are stressed. But consider what the markets allow. Volatility creates opportunities. Now is the time to look for those gaps, weaknesses, and areas of growth; ask “Where are the most productive assets available?”
We have some answers. Call RESIDCO.
The coronavirus was the turning point. Schools and universities are being closed. Public activities are being canceled. Air travel and supply chains are being disrupted. Companies are telling employees to stay put. The virus constitutes a force majeure event.
Even before the U.S. ban on travel from Europe, Air Carriers were reacting by trimming capacity, reducing both domestic and international flights. Southwest Airlines Gary Kelly has said, “The velocity and the severity of the decline is breathtaking, there is no question this is a severe recession for our industry and for us, it’s a financial crisis” (Southwest had previously said reduced bookings could result in as much as $300 million in lost revenue in March alone).
China, in an attempt to contain the outbreak from spreading imposed travel restrictions. Many Chinese factories halted production in February. Worldwide, these shutdowns will impact industries from auto parts to pharmaceuticals.
A key trade flow indicator economists examine is the volume of the Trans-Pacific trade. This trade lane accounts for 40% of the world’s gross domestic product. Despite the recent Phase-One trade deal, the volume of U.S. products moving to China remains depressed. As the virus spreads, political leaders throughout the world are imposing broad travel restrictions. The result is less passenger and freight traffic to move.
Trading relations often come with unseen risks. China’s entry into global markets resulted in a global over-dependence on low-cost Chinese production. The virus has exposed this weakness, and its effects are rippling through the interconnected world economy. “This coronavirus is a wake-up call. We are much more vulnerable than we thought.” Business leaders are scrambling for solutions as they face supply chain disruptions and current market uncertainties. Finding alternative suppliers isn’t easy. Future patterns of trade among nations will change in order to create more supply chain redundancy.
Economic contractions are not a ‘bug’ of free-market systems, but rather a feature. Short term incentives act to create unsustainable swings in everything from product designs to supplier and labor relations. Competition over the delivery of fuel-efficient planes drove the Airbus 320neo and Boeing’s 737MAX (over the past 10 years Boeing and Airbus orders totaled more than 20,000 jetliners). Then, air carriers were more concerned about the cost of jet fuel, their single highest expense after labor.
Surprisingly, when Russia refused last week to join OPEC in its call for crude oil production cuts, the Saudi response was to make the biggest price cut to their crude in more than 30 years Lower oil will help the U.S. consumer, hurt U.S. shale producers, but have little impact on current Air Carrier operations.
The impact of the virus on travel is so large it has resulted in the International Air Transport Association increasing the potential demand shock to the global airline industry upward from its February estimate of $29 billion to a loss of $113 billion in revenues in 2020.
Public market liquidity is a convenience, to be taken advantage of, or to be ignored. We are at a turning point. For actionable insights, call RESIDCO.
Air and Rail Investments
Investor interest continues to demonstrate market confidence in Air and Rail transportation equipment. Increasing interest in these ‘alternative investment’ categories has created a challenging environment. Rail transportation is a high-volume low-value freight business while air is a high-value passenger and freight business. Even with interest rate cuts (three in the last year by the Fed), falling global traffic levels across both modes have created caution flags for near-term investment activity. Whether the cause is tariffs, or the coronavirus outbreak (COVID-19), equipment demand, lease rates, and equipment values are being impacted.
COVID-19 and Travel
China’s rise as the world’s second-busiest market has been a strong source of growth for the world’s major economies and airlines. The virus’ impact on supply chains and passenger traffic is complicated. Air travel is suffering as thousands of flights are being canceled. The International Air Transport Association has published an initial assessment that estimated global lost airline revenue is as high as $29 Billion (airlines in China would be the most impacted).
U.S. carriers completely halted flights to China in January. The US Department of State has issued a level-4 travel advisory, meaning the public is advised not to travel to China. In February, the CDC issued a Level 3 warning, recommending avoiding all nonessential travel to China. In China, Cathay Pacific Airways asked all staff to take three weeks unpaid leave, Hong Kong Airlines Ltd., terminated 400 workers and Asiana Airlines Inc. (South Korea) asked thousands of staff to take unpaid leave. The number of infections worldwide is approaching 80,000 (China’s official count of 74,576 infected, and 2,118 dead is being updated daily1). China is bearing the immediate brunt, but the virus clearly presents a risk to the global economy.
With the delay in returning the 737MAX to service (which is now impacting suppliers, e.g. GE LEAP engines), election-year politics, and the spread of the coronavirus beyond China, it’s difficult to assess the magnitude of impact.
Favorable U.S. Developments?
The leading economic index indicates continued growth, US consumer confidence remains high, labor markets are tight, and existing home sales (supported by lower mortgage rates) are at a two-year peak. The possibility of slower economic activity requires thorough analysis, a sound underlying investment strategy, and downside protection.
Minimize Risk
Risk is inseparable from the opportunity for profit, and whenever there is change, there is opportunity. Transportation equipment investment is no different. In every investment, risk is an exchange: the buyer holds the primary risk, while the seller has given up the chance that equipment values will go up. The biggest economic risk is buying at the wrong price, at the wrong time.
Market intelligence, equipment configuration, and equipment condition are all critical. Equipment ownership and long-term contracts that ensure predictable cash flows and equipment values in difficult markets are needed. Often existing, well-maintained equipment is a better choice than new. Investors should be financially (and psychologically) prepared for volatility. It’s time to review your portfolio and ensure it’s properly positioned to weather the storm that might lie ahead. In times of uncertainty, think long-term and strive to minimize risk.
Prepare Now
We believe the current supply chain disruptions and turbulent global markets will lead to buy-side investment opportunities. Get ahead of today’s challenges. Call RESIDCO.
1 Wall Street Journal, “Coronavirus Wreaks Havoc on Airlines”, February 21, 2020.Market Competition
When a National Bank invests in personal property, the Code of Federal Regulations, Title 12 Part 23, and the Office of the Comptroller of the Currency provides regulatory investment guidelines. Prior to the early 1990s, banks entered into personal property leases only when they were the functional equivalent of a loan (meaning leases had to be “net, full-payout leases”).
As bank regulations relaxed, banks began to enter the operating lease markets by creating operating subsidiaries that met regulatory investment requirements. With their low cost of capital, banks quickly became significant market competitors. Wells Fargo1, CIT, PNC, and Citigroup are examples. They own a significant portion of the national fleet of 1.6 Million units. But with 400,000 railcars in storage and 2019 lease rates down 10 to 20% from the prior year, it has become a challenge to remarket or sell off-lease “nonearning assets” given current market pricing.
Other than intermodal and autos, railcars carry grain, coal, crushed stone, sand, gravel, primary metal products, chemicals, iron and steel scrap, petroleum products, lumber, wood and paper products, and other high-volume, low-value commodities. Shippers want to manage their supply chains and inventory investment by controlling transport capacity and linking deliveries directly to production lines, customer factories, distribution centers, and ports of entry/export.
With several modes of transportation available (truck, rail, air, and river), shippers and railroads are aware of the value of consistent delivery, pricing, and volume; this is what is driving the Class One focus on ‘Precision Scheduled Railroading.’ But by reducing service in insufficiently profitable secondary lanes, the Class 1 railroads are deciding to grow margins and cede market share to alternative modes. The result is the Class One Railroads are using fewer railcars and locomotives.
Rail Traffic as of January 2020
Exacerbating the oversupply of equipment U.S. rail volumes fell (again) in January (their 12th straight decline). Excluding coal (which was down 13.8%) and grain (down 11.6%), U.S. carloads were down .6% in January. Carload gains included chemicals, grain mill products, and metallic ores (carloads of iron and steel scrap were up 5.2%). U.S. intermodal originations fell 5.4% and have now fallen for 12 consecutive months.
Job gains, the Institute for Supply Management’s (“ISM”), Manufacturing Purchasing Managers Index (“PMI”), the Non-Manufacturing Index (“NMI”), housing starts, and consumer spending were bright spots, all higher in January.
Positive trade developments (the new U.S.-Mexico-Canada Agreement – “USMCA,” and the China “Phase One” deal) are being offset by the unknown economic impact of the Chinese coronavirus outbreak. In January, coal carloads averaged 69,706 per week, the lowest January average since before 1988. In the first 10 months of 2019, coal accounted for less than 24% of U.S. electricity generation, down from 27% in 2018, and 50% in 20052. Moreover, weekly average grain carloads in January (19,635) were the lowest for January since 2013.
Investment Solutions
Railcar leasing can provide stable and predictable cash flows as freight volumes return, and the Class Ones show tangible benefits for shippers, such as consistent delivery and pricing that is market competitive. As markets adjust, how can investment results best be managed? For restructuring solutions, seek the advice of independent, unbiased, and experienced counsel. Call RESIDCO.
1Wells Fargo maintains they are the largest railcar lessor in North America, with more than 175,000 railcars.
2Ibid.
Labor and Equipment Demand
Eliminating hump yards and running fewer, longer, ‘scheduled’ trains, the Class One’s are continuing to implement Precision Scheduled Railroading (“PSR”). It’s transforming rail networks, reducing the need for labor and equipment.
The Union Pacific is planning to reduce its workforce by eliminating 3,000 workers this year (after reducing its staff by 11% in 2019). As train speeds increase, the need for rail equipment decreases. It’s estimated that for every one-mile increase in average freight train speed and additional 50,000, additional railcars will be moved to storage. Of a fleet of 1.6 Million railcars, 25% were in storage this January. And train speeds are increasing due to PSR, lingering trade tensions, and to lower freight volumes caused by our slowing manufacturing economy*. Going forward with larger capacity and new cars being delivered, fewer cars will be needed. Added to this, the Rails are losing market share as shippers move product to truck to meet just-in-time inventory requirements.
The Election Effect
Over the years, car ownership has changed dramatically. In 1962 the railroads owned 90% of the freight car fleet. Today, 75% is privately owned. The oversupply of railcars and locomotive power caused by PSR and lower freight volume is acting to reduce market values of existing equipment and lease rates at renewal. The current low-interest-rate environment is depressing lease rate factors available for new equipment. Uncertainty over the fall election and direction of international events (both in the Middle East and Asia) are working to hold the business investment flat. As a result, new railcar deliveries for 2020 are expected to trend down.
Given the election year, Trump signed a “phase one” trade deal with China this January 15th. It provides a measure of relief for rail shippers. China agreed to make purchases of $200 billion worth of U.S. goods over a two-year period, doubling its agricultural purchases to $40 billion. Whether China will honor this agreement (which includes ending its practice of forcing foreign companies to transfer technology to Chinese companies as a condition for access to the Chinese market) is an open question.
The agreement won’t fix everything. There will be a continuing lack of cooperation over technology, national security, military, and political ideologies. These are significant and continuing issues. As the U.S. and China pursue their own national and economic interests, the conflict will continue. A degree of economic decoupling is likely and the future of freight traffic between the two countries remains unanswered. At stake are a stronger economy and global influence.
Globalism, which fostered complex supply chains spanning multiple borders, is retreating. The U.S. has become unilateralist and is rewriting trade rules to prioritize its interests while shunning trade blocs. Bilateral deals have been completed with Canada, Mexico, now China, and soon with Britain, as it has left the E.U. The economic impact of the coronavirus in China is unknown, but airlines are suspending flights and businesses are shutting down operations there.
Investment Risk Planning
As fiscal stimulus fades and global growth slows, U.S. GDP growth is expected to remain at 2%. Even though we’re in the longest bull market in history, overall uncertainty has not been reduced. Tariffs have led to a decline in business investment. While change is certain, how we react to events, preplan for them, and manage through them is within our control.
Struggling to price investment risk and looking for answers? Call RESIDCO.
*The U.S. manufacturing sector contracted for five straight months through December, the Institute for Supply Management.
“A new decade stretches before us.” Crosscurrents from the past decade have swept the unprepared away, so a review of the past decade’s challenges will help instruct future investment. Optimizing investment management will always require a deep understanding of markets, end-user needs, current fleet dynamics, and equipment designs.
Boeing’s 737MAX, the Class One’s singular focus on reducing operating ratios (using Precision Scheduled Railroading), and Commercial Banks focus on earning asset growth (without the tools to fully understand and manage operating investment risk) are examples of mismanagement producing unexpected results. Over the past decade, low-interest rates, private equity, and banks in the operating leasing business have driven yields down. While politics and economics have dominated the news, the following major trends will continue to influence the next decade’s investment decisions.
Technology will drive greater efficiencies and transform customer expectations. Cloud services, information management, data analysis, and the continuing impact of the internet will influence the process and means of global supply chain management. Smartphones and email have created more frequent communication, increasing employee productivity, and making business operations easier. As weather patterns change, reducing carbon emissions will continue to impact air, rail, and marine transportation equipment design decisions. The GE/Safran (CFM) LEAP 1-A and the Pratt & Whitney Pure Power 1100G, geared turbofan are examples of new aircraft engine designs engineered to be more fuel-efficient, quieter, and lower maintenance than current engine options.
Energy. The shale oil boom has sent shockwaves through the energy landscape. Domestic energy sources (shale oil and natural gas) now promise abundant and inexpensive supply. It’s turned coal car investment on its head. But for the next decade, petroleum will remain the primary source of energy for transportation (aviation, diesel, and motor gasoline).
Free markets, social stability, the rule of law, and continuity of effective cooperation drive economic growth. Regardless of a phase one trade agreement, China’s Communist Party will continue to pursue a China first policy. With low labor costs, forced transfer of technology, and intellectual property theft, U.S. policymakers have allowed China to become the world’s largest exporter of goods. What was an attempt to open the Chinese markets to U.S. investment has instead led to the pain of disappearing U.S. manufacturing jobs, and Economic Nationalism.
Government spending. Fiscal policy, interest rates, financial markets, and future tax laws will be driven by the trillion-dollar deficits projected for each year beginning in 2022. Demographic changes (resulting from lower birth rates and diversity caused by immigration) will impact our common social identity, driving populism and political polarization.
Some things remain. The benefits of leasing: lower capital cost, less maintenance, and human resource issues, equipment that is kept up to date, access to the latest design and management expertise. Another constant? Individuals, businesses, and countries will continue to make choices based on maximizing self-interest (A rational analysis should not ignore that humans sometimes rely on emotions rather than facts). We’re in a game with many innings yet to be played.
Guard against groupthink. Invest in assets that generate long term value. Call RESIDCO.
Parsing 2020: restated, third-quarter real gross domestic product increased at an annual rate of 2.1%. As well, consensus economic forecasts predict growth at a moderate pace. Inflation, as measured by the CPI, is expected to edge up. And unemployment is anticipated to remain below 4%. The business fixed investment will continue to slow due to geopolitical uncertainties and the impacts of falling freight traffic.
While the consensus forecast is typically believed to be a rough picture of what is to come, business cycles are irregular, and history has shown that the future can turn out differently than expected. We tend to move in crowds and weigh current and recent experiences more heavily than might be appropriate. It’s clear the Fed’s monetary policy has purposefully inflated asset values. Aside from trade and geopolitical risk, the biggest domestic risk is the continuing low-interest-rate environment and the distortions it is forcing on private equity investors as they search for investment alternatives.
Without a crystal ball, the economy’s current state is most likely the best indicator of next year’s events. But simply extrapolating continuing growth does not mean there is no risk. Asset valuations are highest at the top of a business cycle. Our outlook? Aviation traffic continues to grow. Boeing’s 737MAX will fly in 2020. Both air and rail freight markets will continue to operate in difficult environments.
Successful aviation and rail investment managers have to understand how their markets work and anticipate what will happen next. Being a successful economic policymaker is more difficult. Not only do they have to understand markets, but they also have to make everything turn out well. 2020 is an election year, so politics will influence economic policy. Interest rates will remain low and, even with a ‘Phase One’ deal, trade differences will continue past the fall elections.
The real risk? Government, business, and consumers continue to borrow. As long as borrowing is affordable it drives growth. But wealth gaps increase during asset bubbles, and populism emerges. In a classic asset bubble, interest rates are low, and debt rises faster than incomes. The combination produces accelerating asset returns and growth. Rising income, net worth, and asset values raise the capacity to borrow. It’s a self-reinforcing process. But as debt service payments become equal to or larger than the amount of money available to service them, the condition becomes unsustainable. In a world of higher prices and lower expected returns, the compensation for taking risk becomes too small.
The 2020 Challenge? Managing a transportation lease portfolio in a low-interest-rate environment with low premiums on risky assets. It’s dangerous to reduce the importance of valuation and effective management. Lease investment is a complex form of financing. If a lessee defaults, how much will you recover? The reason to estimate recoveries is it will tell you how to best structure your lease when you first originate it, and, it will tell you the best course of action to pursue if a default occurs. For extensive real-world experience, call RESIDCO.
With more volatility likely, what’s the maximum level of risk you are willing to take in next year’s markets? The answer requires knowledge of the impact changing traffic levels will have on the values of specific equipment types and portfolio credits. Values that will be driven by the economic, financial, and political environment over the next election cycle. A 2020 Roadmap? Maximum returns, minimum risk. With long economic lives, air and rail equipment values, risks, and returns change over time. Investment in transportation equipment requires an evaluation of lessee credit, specific equipment configuration, transaction structures, book and tax accounting treatment, deal economics, and the governing law of the jurisdiction where the equipment operates.
Equipment values are intertwined with the financial condition of operators, the markets, and your perception of the future. Traffic demand drives all three. Recent interest rate cuts by the Federal Reserve and continuing trade relations discussions have bolstered expectations for continued economic growth. Unemployment is at its lowest level in 50 years and the services sector has continued to expand. Since predictions are always risky, what is important is to understand the components of risk, know what you want more of, what you want to keep, and what you would like to sell.
If you choose to sell you should satisfy two criteria. First, the proceeds from the sale should be greater than the proceeds from continuing to hold, and second, the reported accounting treatment should result in a book gain. If you’re selling, consider effective marginal tax rates, not just for yourself but for all participants. Understanding this concept is important since it directly influences prices at which assets are traded. A detailed transaction analysis will help understand why you are making money (interest rates, equipment values, taxes, the equipment markets, etc.), and ensure you are choosing the right thing to do, e.g. good economics and good accounting. The remaining question, where to reinvest the proceeds?
When you made your first investment you made judgments about the lessee credit, future equipment values, and tax rate stability. When you reinvest, you make the same judgments. Diversification of lessees, equipment types, maturities, and the ability to use tax benefits allow you to reduce the overall risk of your portfolio investment. That risk depends on how your lessee credits and equipment (aircraft and railcars) values correlate with one another. A portfolio that contains a lease of a 737 and a lease of railcars creates diversification which reduces risk and which will reduce the amount of capital needed to maintain your investment. The factors that influence the financial health of railroads and railroad shippers are different than the factors that impact the financial health of air carriers. Extending that analysis to companies in the same industry, there are differences in markets served, and equipment types used. The value of diversification depends on how portfolio investments react to changes in macro variables (freight, passenger traffic, interest rates, GDP) and which exposures impact returns the most. Consider your lessees’ ability to manage through economic up and down cycles. Over the next ten years, equipment prices may rise, fall, and then rise and fall again. Manage maturities so not all will face the same equipment value market.
Risk management requires developing a set of expected events and related action decisions that incorporate the probabilities of possible outcomes. Maximize the value of your action decisions by industry, credit, and equipment type. Best case, worst case, most likely. Maintain diversification.
Managing the components of risk requires working with a better investment manager. Call RESIDCO.
RESIDCO’s size and wholesale capability is a competitive advantage. We respond quickly and creatively to ever-changing market conditions.
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