New Equipment Quality Control Issue, Bolsters Demand for Midlife Aircraft
Moving pieces. Third Quarter U.S. GDP growth was revised down to 4.9% from November’s 5.2% second estimate. The National Association for Business Economics is expecting 2024 GDP growth to slow to 1% with a recession risk in the next 12 months under 50%. As inflation slows and with a “soft landing” in sight, the Fed is leaving interest rates unchanged. The federal funds rate is expected to be 4.6% at the end of 2024 down from its current 5.5%, which implies three quarter-point cuts in 2024. Those rate reductions are dependent on the impact current rates have on economic activity and whether inflation is sufficiently close to the Fed’s 2% target (the Fed’s personal consumption expenditures index is expected to approach
2.4% by the end of 2024). The Bureau of Labor Statistics reported 2.7 million net new jobs created in 2023; 672,000 in government, 654,000 in health care, 298,000 in food services, 266,000 in social services, 197,000 in construction, and 12,000 in manufacturing. Transportation and warehousing lost 63,000 jobs[1]. The Index of Consumer Confidence rose to 110.7, in December up from 101.0 in November, reflecting more favorable consumer views of inflation, levels of personal income, and job availability.
U.S. Rail carload traffic for 2023 was 11,701,875, up .7%, the most for a full year since 2019. Carloads were up in 10 of the 20 AAR categories led by motor vehicles and parts, petroleum products, and crushed stone and sand. Intermodal at 12,667,354 units (containers and trailers) was down 4.9% for 2023 but up 5.5% in the fourth quarter over the fourth quarter of 2022, its biggest quarterly percentage gain since the second quarter of 2021. Coal remains the largest U.S. rail carload commodity accounting for 29.2% of total originated carloads. Lease fleet utilization and renewal rates remain favorable.
Boeing’s manufacturing quality control challenges continue as a door plug of a recently delivered 737 Max 9 blew out on January 6th shortly after takeoff. The next day, the FAA issued an emergency airworthiness directive, temporarily grounding 170 of the type to allow investigation and immediate inspection. The door plug involved in the incident was manufactured in Malaysia, and installed by Spirit AeroSystems in Kansas (Boeing’s fuselage supplier), and then apparently removed and reinstalled by Boeing at its Renton, Washington assembly facility[2]. The grounded jets are being allowed to resume flying after mandated inspections are completed. But there are now broader concerns regarding Boeing’s manufacturing assembly, supply chain, and inspection compliance as demonstrated by the FAA Administrator Mike Whitaker’s announcement, “We will not agree to any request from Boeing for an expansion in production or approve additional production lines for the 737 MAX until we are satisfied the quality control issues uncovered are resolved”[3]. As oversight increases Max 9 deliveries will be delayed, further delaying certification of the Max 7 and Max 10 and impacting 2024 air carrier fleeting plans as they consider alternatives[4]. New aircraft may have the latest technology, but OEM airframe and geared turbofan engine quality controls and supplier oversight issues are making air carriers and the flying public more comfortable with the reliability of existing midlife equipment. Identifying placement opportunities for Aero and Rail equipment investment requires expert market insight. Call RESIDCO.
Glenn Davis 312-635-3161
davis@residco.com
[1] The Employment Situation, January 10, 2024, Rail Time Indicators, American Association of Railroads.
[2] Wall Street Journal, “FAA Clears Path for MAX 9”, January 25, 2024.
[3] Federal Aviation Administration, January 24, 2024.
[4] United, Boeing’s biggest customer, is considering fleeting alternatives that do not include the Max 10 which is five years behind its original delivery date.
The Fed’s preferred inflation measure, the core personal consumption expenditures price index (“PCE”) fell to 1.9% in November. This latest data confirms inflation is slowing. On a year-over-year basis, the PCE was 2.6%, the lowest since February 2021. With the full impact of interest rates yet to be felt (housing is struggling, and the Conference Board’s index of leading economic indicators is down 3.3% in the past six months) the Fed remains concerned. “It’s far too early to declare victory and there are certainly risks“[1]. The Fed held rates steady at its December meeting but is now anticipating three rate cuts in 2024. The pivot makes a recession less likely. December projections see the federal funds rate ending 2024 between 4.5% and 4.75%, down from the current range of 5.25% to 5.5% (.75% lower than today). The markets have responded. The S&P is up 14% over the last two months, the 10-year Treasury yield has fallen nearly a percentage point (to 4.03%), and the dollar has dropped 3% against major currencies[2]. The Fed’s estimate of the long-term “neutral” policy rate remains unchanged at 2.5%. That implies that a lower interest rate environment will return even though the Fed is continuing to allow $95 billion a month in proceeds from maturing bonds to roll off its balance sheet (with no indication of stopping).
Aviation capacity issues continue. Airbus and Boeing will have delivered around 1,400 aircraft in 2023 (a 27% increase over 2022). However, the Aero industry continues to grapple with costly and time-consuming quality control issues. Regulators require close monitoring of parts for authenticity and quality. Dealing with manufacturing defects, the certification of aircraft engine components, and airframe maintenance is leading to the grounding of delivered aircraft as well as delays in new equipment deliveries. The resulting shortage of capacity leads to better returns on existing mid-life equipment. Out-of-production single-aisle aircraft have shown meaningful increases in lease rates as the lessor idle fleet returned to service (and there’s not a lot of existing equipment left). New equipment supply remains constrained, underpinning existing equipment values & lease rates. The result is mid-life single-aisle equipment remains in high demand (current OEM backlogs mean the first available delivery slots for new equipment will be in the 2030s).
Even with flat loadings, railcar prices up 12% to 15%. Scrap rates remain elevated. In the last twelve months, railcar lease rates are up 26% to 33%, with lease terms extending to five years[3]. Both GATX’s Lease Price Indicator and TrinityRail’s Forward Lease Rate Differential continue their upward trend. “Forward-looking metrics continue to point toward consistent strength in lease rates[4]. ”Key commodity market demand across all railcar types is driving substantial new equipment order backlogs at both Trinity and Greenbrier. The eleven North American railcar assembly plants have an estimated industry build capacity of up to 55,000 cars annually (FreightCar America’s new production facility in Mexico is expected to deliver 3,150 to 3,300 railcars in 2023). With a soft landing in sight for the U.S. Economy, concerns surrounding inflation and interest rates are subsiding. But, elevated geopolitical risk and 2024 election year dynamics require expert Aero and Rail equipment investment insight. Call RESIDCO.
Glenn Davis 312-635-3161
[1] Fed Chief Powell’s Post Meeting Press Conference, December 13, 2023.
[2] The Wall Street Journal, December 14, 2023 “Capital Account”.
[3] Railway Age, Sea Change in Railcar Supply, December 5, 2023. Higher new railcar prices drive higher lease rates on existing equipment.
[4] Trinity Industries, third-quarter 2023 earnings statement.
Rail traffic volumes remain challenged while Air Carriers face capacity constraints as they attempt to meet the rebound in domestic and international flights. United reported solid domestic and record-breaking international performance with third-quarter revenues up 12.5% year over year. The company set a record for the highest-ever daily average of revenue passengers carried in a quarter (more than 482,000 passengers)1. Delta reported record September quarter revenue ($15.5 billion), a double-digit operating margin (12.8%), and pre-tax income of $1.5 billion. American Airlines reported a third-quarter loss2 resulting from higher costs and a new pilot union contract. Higher labor and maintenance costs and delayed delivery of new aircraft are impacting available capacity and profitability for all three carriers. While fuel costs per available seat mile are lower3 than last year Air Carriers expect oil prices will be volatile over concerns the Israel-Hamas war might escalate.
Airframer delivery delays are being caused by supply chain and new engine reliability issues. In August, Boeing discovered manufacturing defects in the rear of 737 fuselages (mis-drilled fastener holes in a key structural part). That followed an earlier April production disruption caused by incorrectly installed brackets that connect the MAX’s aft fuselage with its vertical tail. As a result, Boeing’s September deliveries of their 737Max jets fell to their lowest level4 in more than two years. The delivery delays and durability problems with the Geared Turbofan and LEAP engines are increasing the values and lease rates of existing mid-life Aero equipment and engines (in August the value of an Airbus A320-200 rose 10% and lease rates for the jet were up 6%).5
On the rail side, total U.S. carloads were down .3% in the third quarter. Union Pacific reported declining freight rail volumes and revenue across their key commodity groups6. UP’s revenue from coal, metals, industrial chemicals, and energy products fell. Carloads of forest products fell 13% as rising mortgage rates impacted home sales (thirty-year mortgage rates are 7.5%, the highest in 23 years). U.S. carloads of grain through the third quarter were down 12.7% from last year, the lowest for the first nine months since 2013 (due to lower exports). Levels of freight rail traffic imply a risk of an economic slowdown (the Manufacturing PMI remains in negative territory for the 11th straight month), but consumer spending isn’t collapsing. Third quarter U.S. GDP grew 4.9% compared to 2.1% in the second quarter. In September, motor vehicles and parts had the biggest carload gains. Consumer sentiment remains stable supported by a strong labor market (a preliminary 336,000 net new jobs were created in September). The Services PMI remains in expansion territory while spending on services is rising faster than spending on merchandise.
More than 300 suppliers are needed to build a Boeing 737 Max. Parts come from more than 50 countries. Geopolitical conflicts are not helping. To better understand and deal with current and expected values and lease rates for Aero and Rail assets, Call RESIDCO.
Glenn Davis 312-635-3161
[2] American lost $545 Million in the third quarter. Revenue was flat with last summer and costs rose. United reported $814 million of expenses during the nine months ended September 30, 2023, associated with agreements with their Pilots Union and other Aerospace Work groups.
[4] Boeing reported 15 new 737 jets, 10 787s, and two 777s for a total of 27 deliveries for the month of September. Reuters, October 2023.
[5] Wall Street Journal, Heard on the Street, October 2023.
[6] Union Pacific Profit Declined as Freight Demand Weakens, Wall Street Journal, October 2023.
Equipment and crew availability affect service levels for both Aero and Rail. Both Rail shippers and the flying public are interested in consistent, reliable service. Rail transit times from pick-up to the last mile are particularly important. The Surface Transportation Board (“STB”), responding to Shipper Rail service complaints, issued a Notice of Proposed Rulemaking (Ex Pate No. 711 (Sub No. 2)) this past September 7th. The new proposed regulations are meant to provide “a streamlined path” to allow reciprocal switching access when rail service to a terminal-area shipper fails to meet any of three performance standards. Those standards are, “Service reliability” defined as a measure of success in delivering a shipment by the original estimated time of arrival, “Service Consistency” meaning a “measure of a rail carrier’s success in maintaining, over time, the carrier’s efficiency in moving a shipment through the rail system,” and third, “Inadequate Local Service” or “measuring a rail carrier’s success in performing local deliveries and pick-up of loaded railcars and unloaded private or shipper-leased railcars within an applicable service window. Comments on the proposed rule are due by this October 23 and reply comments then are due by November 21, 2023.
This August all three of the highest volume carload categories for U.S. railroads, coal, chemicals, and grain, declined. Grain was down 22.9% from August last year. Chemical carloads were down .6% year over year (the 11th decline in the past 12 months). Coal carloads were down 2.8% and were virtually flat year to date (U.S. electricity generation from coal is down 27.3%). Intermodal loadings also were down 6.3% from last year’s August (their 24th year-over-year decline in the past 12 months). Imports and exports at both the major Western and Eastern U.S. ports have decreased, and average truck rates are lower today than in 2022. Loadings for motor vehicles and parts were up 13.6% in August (their 17th straight increase) with the impact of the UAW strike yet to be felt.
U.S. manufacturing activity as measured by the Purchasing Managers’ Index remains down. The PMI has been in ‘contraction’ territory (below 50%) for 10 straight months. Labor force participation is at a post-pandemic high and wage gains in the last three months have exceeded inflation. In July, the Services PMI at 54.5% was the highest it’s been in six months. With rising prices, higher interest rates, a resumption of student loan payments, and tighter credit standards Consumers remain concerned. Existing home sales were down 16.6% year over year (June). The average 30-year mortgage rate was 7.2% at the end of August. The National Association of REALTORS (“NAR”) reports the lowest number of existing single-family homes on the market for July in data that date back to 1982. Rising interest rates have made homeowners reluctant to sell and give up their low mortgage rates.
Despite a Fed funds rate between 5.25 and 5.5% the economy and job markets have remained resilient. Higher rates and new equipment price inflation make lease finance more attractive. Eight in ten businesses use at least one form of financing to acquire equipment (leasing being the most common).
Investing in Aero and Rail equipment offers current cash and significant residual earnings opportunities. To better understand and assess values, Call RESIDCO.
Glenn Davis 312-635-3161
Most Aircraft operating leases provide that the lessee is responsible for maintaining leased aircraft to required industry standards. To ensure flight safety the FAA issues Airworthiness Directives (ADs) and aircraft manufacturers issue Service Bulletins (SBs). ADs are legally enforceable regulations meant to correct unsafe conditions. Airframes, engines, avionics, and other aircraft components (landing gear, auxiliary power units, hydraulics, electrical, etc.) must be properly maintained to ensure flight safety.
Maintenance reserve payments are a critical part of Lessor/Lessee lease negotiations. These ‘supplemental rents’ are generally calculated on a flight hour, flight cycle basis and usually paid on a monthly in arrears basis. New equipment OEM warranties do not cover scheduled maintenance or major inspections. A current example is the troubles with new Pratt & Whitney Geared Turbo Fan (“GTF”) engines which are used in about 40% of Airbus A320neo single-aisle jets. Pratt & Whitney’s parent RTX (formerly Raytheon) Chief Executive Greg Hayes recently made calls to customers[1] (this past July 18th) announcing an investigation had determined that contaminants in a powdered metal used to produce the PW1100 engine’s high-pressure turbine discs (part of the engine core) could lead to premature failure. “Engines delivered between the fourth quarter of 2015 through the third quarter of 2021 will need to be inspected to determine whether repairs are required.” Given time in service, an initial group of 200 engines is scheduled to be checked by mid-September, and up to an additional 1000 engines will need to be removed from service over the next year. Inspection and possible replacement of affected discs requires removing the engine, disassembling, inspecting, and then reassembling; a process that can take up to 60 days for each engine. Air carriers have complained that the GTF engine has had durability issues since introduced. In May, Bloomberg reported about one in eight A320neos and other aircraft with the GTF was in storage for 30 days or longer awaiting repairs (spare parts shortages continue).
Taking equipment out of service for unplanned maintenance results in reduced capacity and disruption of flight crew and support personnel. As an OEM, Pratt & Whitney will be responsible for compensating customers for these engine inspections and repairs as planes are taken out of service. An initial charge of $500 Million has been taken to cover the cost of inspection, repair, and compensation for the first batch of GTF engines being checked. This adds to the more than 100 GTF-powered Airbus A320neo and A220 that have already been grounded due to earlier engine durability problems which included oil leak and vibrations concerns.
For rail equipment, the Federal Railway Administration (FRA) and the Association of American Railroads (AAR) published a set of rules and regulations all railroad car owners (whether private or railroad-owned) must subscribe to in order to operate equipment in interchange service. The interchange rules are detailed in two manuals, the “AAR Field Manual” and the “AAR Office Manual”[2]. The Manuals provide that Railcar Owners are responsible for repairs to their cars necessitated by ordinary wear and tear and for regulatory safety requirements set by the Association of American Railroads. Railinc is the operating arm of the AAR that is responsible for the publication of rules, regulations, and railcar equipment mechanical status. Each handling road is responsible for the condition of cars operating on their line. Railroads inspect and perform “running repairs” to ensure cars are safe to operate. The handling road has the right to send the car owner a bill for necessary repairs. Private (non-railroad) car shops (with lower labor rates) provide service for specialized car types, heavy repairs, complete refurbishment, and an alternative to higher-priced railroad running repairs. There are literally hundreds of components and a myriad of reasons for railcar repairs. Proactive management and audit of repair bills are required to ensure the right repair is being made and the right price is being charged. The Manuals also provide for damage settlement occurring resulting from unfair usage or improper protection by the handling road. With a freight car fleet of 1,625,000 cars, imagine the amount of data that is available.
Looking for answers? Call RESIDCO, a proven Aero and Rail equipment management team.
Glenn Davis, 312-635-3161
[1] Jet Blue, Spirit, Hawaiian Airlines, Wizz Air, Lufthansa, Mexico’s Volaris, and others.
[2] Association of American Railroads (AAR), Digital Field and Office Manuals.
Pent up demand from pandemic lockdowns. Government stimulus ($5 Trillion). The Fed’s past abnormally low interest rate policy. These are the causes of the current distortions in economic activity. U.S. annual Core consumer price inflation remains high, 5.3%[1]. Wage growth continues. American Airlines pilots agreed to a new contract that boosts pay by 21% in 2023. Recent Class One national labor agreements resulted in a 24% wage increase during the five-year period from 2020 to 2024[2].
Current travel demand has driven Air Carriers back to nearly 100% of 2019 operations. Even with higher ticket pricing, there has been no slowdown in bookings. The lack of currently available new equipment[3] has resulted in a strong demand for immediately available narrowbody aircraft. Air transport markets are highly competitive, with low-profit margins. Fuel and labor are significant components of Air Carrier operating expenses. Any variation in these costs directly impacts operating profits. Lower energy prices and new engine technology provide direct economic benefits allowing more competitive pricing. Crude oil prices are down. July contracts for West Texas Intermediate (“WTI”) crude recently settled at $72.58 a barrel while Brent crude (the global benchmark) was $77.14 a barrel. China’s economic restart is stalling, Russian crude is continuing to flow, and the uncertain direction of the global economy is driving crude oil down further (WTI closed at $69.51 after the Bank of England raised interest rates to 5%). Without substantial technological improvements in alternative propulsion systems (or significant increases in the cost of crude), current equipment will remain competitive.
U.S. GDP data shows consumers are spending, and companies are hiring. In their June meeting the Federal Open Market Committee (“FOMC”) decided to leave interest rates unchanged (target range now between 5%-5.25%). Fed Chairman Powell signaled two more increases this year. Individual members of the FOMC expect a rate of 5.6% by the end of 2023. Rising interest rates paired with persistent inflation have led the Conference Board to predict, “A contraction of economic activity leading to a mild recession.” The Conference Board’s Leading Economic Index (“LEI”) is designed to provide an early indication of turning points in the business cycle. It’s declined in each of the last fourteen months. But 339,000 net new jobs were created in May (double what economists expected), auto sales are holding up, and April single-family housing starts were the most in four months.
Air transport is integral in the globalization of transport networks. More efficient engines and better aerodynamics have improved with each new generation of aircraft. Underlying price pressures and recession fears may lead to a slowing economy, but the U.S. economy continues to perform. The result is far fewer mid-life narrow-body aircraft are being retired. The pivot toward clean energy has begun but will take time and investment to complete.
It’s clear Aero and Rail needs will continue. Positioning transportation investment for the future requires underwriting discipline and an understanding of what drives demand for existing midlife Aero and Rail equipment. Build your portfolio strategically by focusing on practical solutions and best practices underwriting strategies. Call RESIDCO.
Glenn Davis, 312-635-3161
[1] Trading Economics, May 2023 data.
[3] “We cannot make planes fast enough to satisfy demand” Guillaume Faury, Airbus, Paris Air Show.
Locomotives, typically classified as 50-year assets, are primarily electrically driven. Despite the common label as ‘diesels,’ they are better described as ‘hybrid-electric’ vehicles. This is because their diesel engine powers an alternator which generates the electricity required to operate the electric traction motors mounted on the locomotive’s axles. As reported by the American Association of Railroads, transporting freight by rail is three to four times more fuel-efficient than highway transportation. Trains are capable of moving a ton of freight, approximately 492 miles on just a single gallon of fuel1. Yet, investing in a current Tier 4 locomotive today implies that you may still be burning carbon-based diesel well past 2050.
As both the Aero and Rail industries strive to incorporate cost-effective zero-emission technologies, there is active investigation into next-generation equipment and fuel alternatives. Among these is the application of hydrogen, a ’clean’2 fuel, either through a hydrogen internal combustion engine or via a reaction with oxygen inside a hydrogen fuel cell. These fuel cells use hydrogen to generate electricity. The world’s first passenger trains powered by hydrogen fuel cells, which produce the electric power to drive the traction motors, are already in commercial service in Germany, specifically for short-haul suburban rail services. In the U.S., companies like Caterpillar, Wabtec, Progress Rail, Cummins, and others are undertaking efforts to verify the feasibility of hydrogen as a viable substitute for traditional fossil-based fuels in line-haul services.
There exist alternatives to batteries for achieving net-zero transportation. Fuels made from non-petroleum sources, often labeled as ‘sustainable’ fuels, are derived from alternative sources in contrast to fossil-based fuels. These include oils from plants, algae, greases, fats, waste streams, alcohols, sugars, or captured CO2. Hydrogen, the simplest known chemical element, offers the highest energy density of any fuel. The byproducts of using hydrogen as an energy source are environmentally friendly heat and water.
Aviation fuels are distinctive due to their ‘specific energy’3, or energy per unit of mass. The current Jet-A fuel is a carbon-based kerosene fuel. While hydrogen offers three times the energy of kerosene per unit of mass, it demands four times the volume of the current Jet-A kerosene-based fuel to achieve the same outcome. The possibilities for hydrogen-based aircraft propulsion include electric motors powered by fuel cells, hydrogen-powered gas turbines, or hybrid systems that incorporate both fuel cells and hydrogen-based gas turbines. For short to medium-range aircraft, conventional gas turbine engines could be modified to use liquid hydrogen combustion. Hybrid aircraft, powered by hydrogen fuel cells, are currently being explored as zero-carbon alternatives. However, integrating hydrogen as a fuel source will likely necessitate the redesign of aircraft configurations4.
New technologies frequently come with high costs and are not instantly practical. The economics and investment timelines needed to transition to reduced carbon alternatives remain subjects of exploration. This transition will entail long-term efforts in designing new equipment, developing necessary material supply chains, devising cost-effective energy production alternatives, and establishing Aero and Rail fuel distribution and logistics networks. Despite the remaining challenges, investment in current midlife Aero and Rail equipment appears more attractive. Opportunities with lower risk and existing cash yielding attributes are available. Call RESIDCO.
Glenn Davis, 312-635-3161
1. Aii – Do Longer Trains Pose Problems or Solutions?
2. Office of Energy Efficiency & Renewable Energy – Hydrogen Fuel Basics
3. Wikipedia: Aviation fuel – Energy Content of Aviation Fuel
Weight and balance limits of aircraft are crucial for ensuring flight safety. Incorrect weight distribution significantly impacts flight performance, and neglecting or performing incorrect preflight calculations can have fatal consequences. From 2008 to 2016, approximately 136 general aviation accidents were likely caused by pilots failing to complete or conduct preflight performance calculations for weight and balance. About one-third of these accidents led to fatalities for pilots and/or passengers1. The pilot in command holds the responsibility for aircraft loading, crew, passengers, baggage/cargo, fuel, and ensuring compliance with center of gravity limits and maximum weight restrictions.
With the adoption of Precision Scheduled Railroading (PSR), Class One railroads are operating longer trains. The arrangement of cars, whether empty or loaded, short or long, impacts a train’s ability to safely navigate the tracks. Poorly assembled trains elevate the risk of derailments. Longer trains enable fewer employees and locomotives to complete a trip compared to running multiple shorter trains. This reduction in equipment needs improves system velocity and lowers the operating ratio. Although distributed power units and dynamic braking enhance train handling, they do not rectify human errors in navigating challenging terrain or poorly assembled trains. Longer trains are more prone to derailments when there is improper weight distribution, leading to the train separating on inclines or curves2, or empty cars derailing due to trailing weight.
Mechanical issues with equipment are also a significant concern. Rail operators oversee the composition of trains and the placement of trackside “hot box” detectors3. Initial analysis of the recent Norfolk Southern East Palestine incident indicates that it was caused by an overheated wheel bearing. The East Palestine derailment could have been prevented if Norfolk Southern had placed hotbox detectors closer together. The Federal Government lacks regulations mandating the use of temperature detectors along tracks, as well as guidelines for their placement, inspection, and maintenance. Following the East Palestine derailment, the Federal Railroad Administration (FRA) released its initial advisory, urging railroads to enhance the positioning of trackside safety detectors. The American Association of Railroads (AAR) interchange rules outline the responsibilities regarding equipment inspection and necessary “running” repairs before railcars are interchanged. When cars go through interchange, the railcar owner bears the financial responsibility for repairs carried out by a railroad’s “running repair agent”. These repairs are invoiced at AAR labor rates4, which are notably higher than rates in private contract shops.
In aviation, new technologies often carry inherent risks. Pratt & Whitney’s PW1000G geared turbofan engine is a case in point, with many units requiring retrofits. The time on wing before overhauls is approximately 10,000 hours, roughly half the duration of existing Pratt & Whitney V2500 engines.
Effectively managing investment risk for Aero and Railcar portfolios entails considerations beyond lessee credit, lease term(s), pricing, and equipment service lives. The operations and maintenance practices of lessees can generate undesirable publicity and lead to intricate legal proceedings. Collaborate with an investment management team that possesses a deep understanding of these risks. Call RESIDCO.
Glenn Davis, 312-635-3161
On March 23rd, 2023, the Federal Reserve voted unanimously1 to raise the interest rate paid on reserve balances by a quarter of a percentage point to 4.9%, marking the highest level since 2007. Although the federal funds rate range of 4.75% to 5% is above the Federal Reserve’s 2% target inflation rate, the annual inflation rate in the United States remains high at 6% for the 12 months ended February 2023, as per U.S. Labor Department data published on March 14th. This suggests that the Federal Reserve will continue to raise its benchmark rate. However, for Aero and Rail borrowers, higher interest rates will affect their ability to refinance maturing debt. Moreover, the banks are not accounting for duration risk in their ‘risk-weighted’ capital calculations. According to US GAAP, the value of “held-to-maturity investment assets” can be reported on the balance sheet at maturity values, which does not reflect their lower current market values in a rising interest rate environment. This is causing the current banking turmoil, which the Federal Reserve is addressing with a new Bank Term Funding Program (announced on March 12th), lending to banks at par against their held-to-maturity assets.
According to records dating back to 1988, February rail freight recorded its lowest total carload volumes (excluding intermodal originations). The decline in rail freight demand began in mid-2022. As retailers faced declining sales, they became more cautious and cut inventory levels. This was reflected in U.S. retail sales which were down 0.4% in February, the third decline in four months. In the first 11 weeks of 2023, rail freight volumes were down 5.2% compared to last year. February container imports at the ports of Long Beach and Los Angeles (the nation’s busiest) were down 38% year over year. Intermodal truck-rail was down 9.6% in the same period, with a 15.2% dip in the week ending March 18th. There is good news though. The Surface Transportation Board approved the CP/KCS merger2 4-to-1 on March 16th. The Board expects that this new single-line service will foster growth in rail traffic, shifting approximately 64,000 truckloads annually from North America’s roads to rail, and will support investment in infrastructure, service, quality, and safety. Moreover, rising interest rates make equipment leasing more attractive for both shippers and Class Ones, as they opt to maintain liquidity. This same dynamic will also influence commercial air carriers as they face similar market conditions. Although growth prospects for rail freight are mixed, these factors may help mitigate the decline in demand.
According to Delta’s Chief Executive, Ed Bastian, the airline recently had its highest sales days3 in its history. With more normal levels of aircraft utilization returning, air carriers are finding that the latest generation turbines (the LEAP and GTF engines used on the A320neo and 737MAX) are more fuel-efficient but not as reliable as existing technology CFM56 engines. The newer engines run hot, turbine components wear more quickly, and engine time on wing before removal and maintenance is required is not meeting expectations. Once in the shop, there are long waits for parts, and the availability of engine components is being impacted by the Airframer OEMs high demand for new engines. As a result, existing equipment remains in demand, as Air Lease Corp. Chairman Steven Udvar-Hazy stated that roughly 90% of aircraft leases are being renewed due to production delays at Airbus and Boeing.
The Bank stress that has appeared results from the extended period of unusually low interest rates. Equipment valuations and lease pricing will adjust in response. Regardless of ambiguities in the direction of demand, inflation, and geopolitics, capital should be allocated to productive opportunities. Existing Aero and Rail assets provide those opportunities. Call RESIDCO.
Glenn Davis, 312-635-3161
[1] Implementation Note issued March 22, 2023 – https://www.federalreserve.gov/newsevents/pressreleases/monetary20230322a1.htm
[2] STB Approves CP/KCS Merger With Conditions and Extended Oversight Period – https://www.stb.gov/news-communications/latest-news/pr-23-07/
[3] Delta Air Lines CEO Ed Bastian: There is still unmet demand for airlines due to the pandemic – https://www.cnbc.com/video/2023/01/13/delta-air-lines-ceo-ed-bastian-there-is-still-unmet-demand-for-airlines-due-to-the-pandemic.html
After increasing 3.2% in the third quarter year, the U.S. economy grew at a 2.9% annual rate in last year’s fourth quarter. The Federal Reserve’s preferred price index slowed to 3.2%. Inflation appears to be cooling, but labor, and supply chain challenges remain. Higher interest rates are impacting demand in manufacturing and services. The labor market remains tight. Unemployment is at 3.5%, matching a half-century low. Fourth quarter GDP reflected increases in inventory investment and consumer spending, partly offset by a decrease in housing.
Whether the Federal Reserve can engineer a soft landing or not, a slowing economy will impact rail freight traffic demand. Rail freight volume growth is now projected to be less than 1% for 2023. Train speed velocity is a key metric that impacts equipment availability. Class One “Scheduled Railroading” operational plans will need to be adjusted to emphasize velocity improvements. Train crew shortages must be resolved. Both the Roads and Rail Shippers face higher new car pricing, driven by railcar production cost, steel and tight component availability. Car availability has tightened as railcar retirements have outpaced new deliveries for the third consecutive year1. Railcars in storage are down. Thirty-seven percent of the stored fleet has been inactive for over 1 year and will either be scrapped or repurposed if economically possible. Covered hoppers are being converted to from 3,250 to 4,751 cubic feet, allowing different product service such as potash, sugar, grain, and distillers dried grains. Suboptimal units in storage are likely to be scrapped. Tight equipment supply is supporting existing car pricing and lease renewal rates for both originations and renewals.
Demand for air travel continues to outpace the industry’s ability to meet it. United, Delta, and American are all reporting resilient demand, seats packed and fares higher. Delayed new aircraft deliveries are restricting the industry’s ability to adequately respond to the rebound in passenger demand. At United’s January 18th earnings call, Scott Kirby, United’s chief executive, argued fundamental changes have occurred: “Across the board there are supply-chain constraints, technology infrastructure issues, a pilot shortage, workforce constraints (lower experience levels of new hires) and, airframers are struggling to meet delivery targets.” A logjam in engine repair capacity has left planes grounded as their engines are late coming out of overhaul. During last summer, more than 1,300 aircraft were returned to service from storage. Compared to pre-COVID levels more than 1,700 single-aisles and 900 twin-aisles remain in storage2. Detailed analysis of the stored single-aisle units project 60% are projected to return to service3.
Yields on short-term Treasurys have held above those of longer-term debt, a signal to expect slowing growth. Globalization isn’t dead but changing. More attention is being paid to geoeconomic risk. Nations are balancing growth and low inflation against defending national interests. While the risk of a recession cannot be dismissed, the odds of a soft landing are getting better. With Covid receding, longer run issues are coming into focus. Prices are likely to go higher as constrained supply continues to drive equipment values and lease rates.
Concerned about the path of demand and inflation? Call RESIDCO.
Glenn Davis, 312-635-3161
[1] Greenbrier CEO Lorie Tekorius, Midwest Rail Shippers Winter Conference, 2023 Rail Equipment Update, January 18, 2023
[2] Cirium Fleets Analyzer, Western-built passenger jets, New Year Resolutions, January 26, 2023
[3] Ibid.
RESIDCO’s size and wholesale capability is a competitive advantage. We respond quickly and creatively to ever-changing market conditions.
70 W Madison St, Suite 2200
Chicago IL 60602 – 4275
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