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
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.
The International Air Travel Association expects the global aero industry to earn a $4.7 billion profit in 2023. U.S. and major European air carriers are better off than Asian (particularly China) carriers. Coming out of the pandemic, pent up air travel demand increased domestic load factors. Equipment and labor became operational challenges. As capital costs increased lease rates climbed. Both major airframers, Boeing and Airbus, continue to deal with supply chain issues1 and are unable to ramp up production as much as they would like. Inflation continues to drive increasing labor costs. Delta pilots reached an agreement (after three and a half years of negotiations) for an immediate 18% pay raise and a cumulative raise of 34% after three years. To deal with the pilot shortage, single pilot commercial aircraft operations are being explored. Over 40 countries including Germany and the United Kingdom have asked the United Nations body that sets aviation standards to help enable single-pilot flights. In November, Congressional action blocked a rail strike with a 24% pay increase over five years through 2024.
The $1.65 trillion Omnibus Appropriations bill funds the government through September 30, 2023. More spending will drive inflation down and continue job market strength. The Services PMI strengthened in November and is firmly in “expansion” mode. According to the “third” estimate released by the Bureau of Economic Analysis, the real gross domestic product (GDP) increased at an annual rate of 3.2% in the third quarter. The U.S. Bureau of Labor Statistics reports over the last 12 months the Consumer Price Index for all urban consumers increased 7.1% before seasonal adjustment2. At its December 14, 2022 meeting, the Federal Reserve raised its benchmark rate a half-point to a range of 4.25% to 4.5% (its highest level in 15 years). All indications point to higher rates in 2023.
Exemptions for the 737 Max 7 and 10 were included in the Omnibus Appropriations bill. Requirements include retrofitting with a synthetic enhanced angle-of-attack system and the ability to shut off stall warning and overspeed alerts. The retrofit work is to be completed (at Boeing’s expense) within three years from the time the 737 MAX 10 is certified and will be required on all 737 MAX jets.
Forecast farm net income is expected to surge to $160.5 billion this year3, the highest since 1973 when adjusted for inflation. Prices for corn and wheat have soared since Russia’s invasion of Ukraine. Reduced grain stock and continued pressure on Black Sea exports mean pricing strength will continue. Carloads of chemicals and grain are the second and third highest volume carload commodities for railroads. Carloads of coal are the single highest volume carload commodity4 at 28.4%, twice as much as chemicals at 14.2%, and three times as much as grain 9.6%. The International Energy Agency has stated, “Coal will continue to be the global energy system’s largest single source.” In Europe, coal use has returned with coal plants brought back online. In the first two weeks of December, Germany generated 49% more power with coal than in the same period a year ago as Russian coal has been banned as a result of sanctions on Moscow’s invasion of Ukraine.
Despite current macroeconomic conditions, lessors and equipment producers are seeing higher lease rates and equipment demand. We’re optimistic about 2023 opportunities. Call RESIDCO.
Glenn Davis, 312-635-3161
[1] Boeing suspends Russian titanium as Airbus keeps buying, Mar. 2022
[2] CPI Up 7.1% over the year ended November 2022, Dec. 2022
[3] High Commodity Prices Feed a Boom in the U.S. Farm Belt, Dec. 2022
[4] Rail Traffic for December and the Week Ending December 31, 2022, Dec. 2022
In an environment where uncertainty is commonplace, investment in transportation equipment is often driven by residual value estimates as lenders and lessors compete for market share. Many factors influence the future value of equipment. Most are not very predictable. All require an active aftermarket for the asset under consideration. Physical factors include wear and tear and useful life estimates. Technical factors impact value when newer (more efficient) designs appear causing demand factors to change. Regulatory factors occur from time to time as government imposes new requirements. The FAA’s current review of the 737 Max MCAS and safety procedures for earlier 737 models is an example. Additional flight crew training is expected (even on the 737NG models) including emergency procedures, maintenance training, and an evaluation of pilot response times. Macroeconomics, tax regimes, and global trade impact pricing. In both expanding and contracting markets, investors and their advisors track the behavior of sale prices purchased new, when returned from lease and sold into the secondary market, and similarly track lease rates for short, mid, and longer term leases. In these different environments releasing at lease end, prior to sale, adds value and reduces investment risk.
Residual valuation estimates future equipment value by establishing a relationship between the historical price of equipment and the most appropriate relevant factors. It is particularly useful when making long term investment decisions for both aviation or rail assets. Once you identify factor relationships you have access to a wide body of knowledge about basic economic variables such as GDP, interest rates, commodity pricing, and the impact of international politics on global trade. This is important simply because there are more experts with reasoned views on these topics than there are on the future pricing of air and rail assets.
A key component in this process involves estimating correlation between the various factors. Estimates of value are described in terms of a distribution rather than a point estimate. Standard deviation is a measure of risk and variability of returns. The higher the standard deviation, the higher the ‘riskiness’ of an investment. In simple terms, the standard deviation measures how much variance exists around the average. The coefficient of variation is useful in determining which investments have more relative risk when investments have different average returns. The coefficient of variation tells us the probability of experiencing a return close to the ‘average’ return. The higher the coefficient of variation, the riskier an investment per unit of return. Covariance is a measure of how price movements between investments are related to one another. Correlation is a scaled version of covariance that takes on values between -1 and +1. A correlation of +1 denotes that two assets are positively correlated. A correlation of zero denotes that assets are completely uncorrelated. A correlation of -1 denotes a perfectly negative correlation.
Investors are rational. Markets are efficient. Managing portfolio risk in an uncertain environment recognizes values can increase as well as decrease. Your tools should incorporate disciplined analysis combined with optimal use of available information. Uncertainty requires understanding there are factors which cannot be quantified.
Forethought, diligence, statistical analysis, confidence in equipment alternatives. Sound decision making in real time. Looking for Alpha? Call RESIDCO.
The Importance of Infrastructure
Infrastructure is one of the main factors of economic growth. This includes power, water, telecommunications, ports, roads, and rail. In a report by McKinsey Global Institute, the projected requirement for infrastructure investment is estimated to reach $57 trillion dollars from 2013-2030. This is to keep up with global GDP growth targets. According to PWC, globalization enabled free movement and distribution of goods around the world, while travel and people to people linkages enabled the movement of data and currency. Such massive activity is only possible through physical and digital infrastructure. Due to the expected shift in economic and demographic trends, there is an enormous need for boost infrastructure spending.
According to the Business Roundtable, statistics show the need for improvement in America’s infrastructure spending: the infrastructure quality of the U.S. currently ranks at no. 16 globally, behind France, Japan, and Germany. Among the world’s top 50 airports, the U.S. only has 4 included in the list; delays and congestion have amounted to $24 billion losses in 2012 alone. Around 25% of rails around the country is marked as “good” or “excellent.” Clearly, there is a lot of room for improvement. The U.S. economy would greatly benefit from massive infrastructure spending.
An article by the Council of Foreign Relations mentioned the current state of U.S. transportation infrastructure. Many highways and bridges in the U.S. will reach the end of their maximum expected lifespan, thus the need for adequate capital investment in order to conduct major repairs to these infrastructures. The last era where transportation infrastructure has benefited was during former President Eisenhower’s time until the 1980s. Afterward, spending on transportation infrastructure has significantly declined.
Short and Long-term Benefits of Infrastructure Investment
Infrastructure investment can have short-term and long-term economic benefits. Building and construction efforts will result in a boost in employment; more jobs will be created. Long term gains involve sustained economic growth with greater benefit for the population, with better services and smoother flow of people, goods, and services associated with high-quality transportation, better roads, rail, airports, and seaports, among others.
Admittedly, transportation infrastructure requires a significant amount of capital investment, and traditional government funds may not be enough. This is where the private sector can come in. The Financial Times mentioned that some policy experts advocate for greater private sector involvement in infrastructure investments, mainly through public-private partnerships or PPPs. PPPs are projects done in long-term contracts, with direct cooperation between the public and private sector. Private capital can then fund infrastructure through municipal bonds. Ultimately, there are risks and returns to be considered but this may vary depending on the project involved. As mentioned in the article, a public-private sector partnership may result in lower costs in terms of technological or operational components or expertise, compared to a public sector-led initiative.
The bottom line is that there is a massive need for transportation infrastructure investment in the United States, and there is no better time to invest than now. Investing in transport infrastructure means investing in the future and ensuring long-term economic benefits for the country. This unique opportunity is sustainable and its effects are long lasting. As emphasized in the Business Roundtable report, the following benefits can be obtained with increased investments in the transportation infrastructure:
Increased GDP growth – investment in transportation infrastructure will generate more jobs; the maintenance and repair projects will further boost employment and create jobs that are permanent and well-paying, which can benefit the middle class, resulting in an increase in GDP growth.
Increased productivity – Efficient and modern infrastructure translates to greater productivity by improving safety, reducing labor costs, fuel expenditures, travel time and other unnecessary effects of uncertainty. Supply chains run more smoothly and the cost of doing business is lower.
Increased international competitiveness – High-quality infrastructure will attract foreign direct investments and encourage businesses to expand their operations.
Investing in Transportation Infrastructure
Investment in transportation infrastructure will result in highly sustainable, short- and long-term economic gains. It is a win-win solution and a unique opportunity that businesses should take advantage of. Infrastructure plays a crucial role in providing employment opportunities, increasing productivity and boosting international competitiveness, and is a proven key factor in driving economic growth. To know more about investing in transportation infrastructure, call or visit RESIDCO for more details.
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