Macroeconomic drivers of airlines share prices in the Asia Pacific

1st March 2017, Asia Pacific - We examine the macroeconomic drivers of airlines share prices in the Asia Pacific. One may not necessarily know much about the airline industry or individual company drivers and still earn a handsome return from trading some of the more liquid airline stocks. Here are some macro trade ideas that have worked in the past and remain relevant going forward:

+ FUEL PRICE MOVEMENT

Airlines hate volatile oil prices but investors can profit from them.

Did you know?

The price performance of the airline equities in the Asia Pacific used to be positively correlated with fuel prices before 2011. This was mainly because rising fuel prices tended to be driven by a stronger global economy which also drove air travel demand and a more positive earnings outlook for the airline sector which in turn lifted their share prices.

During periods of more balanced industry demand and supply, the airlines could pass on a significant portion of the fuel price increase to their customers, thus avoiding significant profit margin erosion. As such, investors were generally less concerned about the risk of higher fuel prices on airline earnings. Even when spot jet fuel price surged 429% from US$21/bbl in January 2002 to US$111/bbl in Dec 2007, the Crucial Perspective Asia Pacific airlines stock index earned a return of 187% during the same period before taking into account dividends.

What has changed?

This positive correlation broke down 5 years ago. In fact, the Asia Pacific airline sector’s share price performance has become more and more negatively correlated with jet fuel prices, especially in the past 3 years.

The key reason behind this is that the industry oversupply has prevented the airlines from passing on more than half of the fuel price increase to their customers. This lack of pricing power was again reflected from 2H15. When fuel prices collapsed in 2H14, the Asia Pacific airline sector rallied sharply initially but started to correct from 2H15 as the industry oversupply drove the airlines to compete more aggressively on pricing, passing on a large part of their fuel cost savings to their customers, failing to lift their own profitability meaningfully from the lower operating costs.

Spot jet fuel prices have risen 56% y/y to US$65/bbl although still 33% lower than the US$98/bbl average spot jet fuel price that the airlines paid in the past 10 years. If fuel prices continue to trend higher in 2017, the Asia Pacific airline sector’s share price performance could correct or be range-bound unless their pricing power improves, enabling them to pass on more of the fuel cost increase to their customers. Their ability to do so will ultimately depend on the industry’s demand-supply balance which we discuss in detail in our reports on the global and Asia Pacific airline sector’s short term capacity outlook.

Looking back if hindsight were 20-20:

  • If investors shorted the Asia Pacific airline stocks back in Dec 2007 when jet fuel prices spiked up sharply, they would have made a 58% absolute return in 1 year and outperformed the MSCI Asia Pacific market index by 14%.
  • If investors bought the Asia Pacific airline stocks in June 2014 when jet fuel prices collapsed, they would have made a 92% absolute return in 1 year and outperformed the MSCI Asia Pacific market index by 85%.
  • If investors shorted the Asia Pacific airline stocks in January 2016 when jet fuel prices started to creep up again, they would have made a 12% absolute return in 6 months and outperformed the MSCI Asia Pacific market index by 10%.

Chart: Asia Pacific stock index versus spot jet fuel price

Macroeconomic driver of airlines share prices Chart: Asia Pacific stock index versus Spot jet Fuel Price

+ EXCHANGE RATE MOVEMENT

Savvy currency strategists would make good airline investors.

If you are good at predicting currency movements, you are more likely to make handsome profits trading in and out of the leveraged Asia Pacific airlines as the impact of their home currency movements on airline stocks often overshadows the other fundamental earnings drivers.

The strengthening of the US dollar against their local currencies tends to be negative for the Asia Pacific airlines as they have more USD-denominated costs than USD-denominated revenue and aircraft capex is also paid in USD and often financed with USD debt or USD leases.

As the Asia Pacific airlines tend to fund their capex with a sizeable level of USD debt, this results in unrealized foreign exchange translation losses (gains) that the airlines are required to mark to market and book at the end of each reporting period when the US dollar strengthens (weakens) against their local currencies.

For leveraged airlines with high US dollar debt levels, this forex loss (gain) tends to be disproportionately larger than their recurring earnings impact from the stronger (weaker) US dollar. Although it is a non-cash item and could potentially reverse if the local currency rebounds against the US dollar in the future, the stock market tends to react negatively (positively) to Asia Pacific airline stocks when the US dollar strengthens (weakens) against their local currencies.

Chart: AirAsia share price versus Malaysian Ringgit exchange rate

Macroeconomic drivers of Airlines share prices Chart: AirAsia share price versus Malaysian Ringgit exchange rate

Chart: Korean Air share price versus Korean Won exchange rate

Macroeconomic drivers of airlines share prices Chart: Korean Air share price versus Korean Won exchange rate

Chart: China Southern Airlines share price versus Renminbi exchange rate

Macroeconomic drivers of airlines share prices Chart: China Southern Airlines share price versus Renminbi exchange rate

What’s counter-intuitive?

Interestingly, the Japanese airlines’ share price performance is positively correlated with the US dollar even though they are also short of US dollars. This could be due to market expectations of increased inbound tourism traffic when the Japanese yen weakens. Note that the share price correction in 2008-2009 was also driven by the global financial crisis.

Both ANA and JAL could be suitable stocks to go “long” in a pair trade when the US dollar strengthens against the Japanese yen for investors who are planning to short the other Asian airline stocks when their local currencies weaken against the US dollar.

Chart: ANA Holdings share price versus Japanese Yen exchange rate

Macroeconomic drivers of airlines share prices Chart: ANA Holdings share price versus Japanese Yen exchange rate

+ AIR TRAVEL DEMAND

Being a contrarian investor pays off.

Buy airline stocks when travel demand is bad but no longer worsening: Investors maximize their returns by buying the Asia Pacific airline sector during periods of industry downturn and/or demand shocks (due to economic recessions, terrorist attacks, disease outbreak) when air traffic has collapsed and is bottoming out.

Avoid waiting until these companies report their strong financial results to take profit: By the time air travel demand growth rebounds strongly and peaks, it is usually an optimal time to take profit, rather than wait until the results reporting season when the Asia Pacific airlines report their strong earnings recovery.

Chart: Asia Pacific airline stocks index versus sector passenger traffic growth

Macroeconomic drivers of airlines share prices Chart: Asia Pacific airline stocks index versus sector passenger traffic growth

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