Airlines

Highlights Portfolio Strategy Most of the macro and operating indicators we track are sending conflicting messages on the anticipated direction in the cyclical/defensive ratio. Stay on the sidelines on cyclicals versus defensives. While the coronavirus epidemic will take a bite out of airline demand in the near-term, firm consumer confidence, rising consumer outlays, recovering services PMIs, rising airline pricing power, falling kerosene prices, compelling relative valuations and oversold technicals, all signal that airlines are well positioned to regain altitude on a cyclical time horizon. Recent Changes There are no changes to our portfolio this week. Table 1 Will The Fed Save The Day, Again? Will The Fed Save The Day, Again? Feature The SPX shrugged off the persistently negative coronavirus epidemic news and made fresh all-time highs last week (top panel, Chart 1). Domestic flush liquidity remains the dominant macro theme coupled with the expectation of a sizable fiscal and monetary easing out of China in the coming months. Importantly, according to the CME there is a 60% chance of a Fed interest rate cut priced in for the July 29, 2020 FOMC meeting which jumps to over 80% probability for the December 16, 2020 meeting. This is sustaining downward pressure on the 10-year Treasury yield, which in turn is boosting equities. A glum JOLTS report along with the 12-month fed funds rate discounter corroborate that additional Fed easing is likely nearing (middle & bottom panels, Chart 1). Chart 1Is A Fed Interest Rate Cut Looming? Is A Fed Interest Rate Cut Looming? Is A Fed Interest Rate Cut Looming? Chart 2Unsustainable Rise In “Tenuous Trio” Unsustainable Rise In “Tenuous Trio” Unsustainable Rise In “Tenuous Trio” The extreme concentration in excess returns in a handful of tech stocks is another potential trouble spot for equities that we have been highlighting recently. Nevertheless, beneath the surface trouble is brewing. Chart 2 shows three asset classes rising concurrently. The “tenuous trio” as we have called stocks, Treasurys and the greenback in the past, cannot rise in tandem. When all three asset prices appreciate, it typically foreshadows equity market trouble. In this particular iteration, even the VIX is up for the year, representing a big break in historical correlations. Worrisomely, since 2018 every time the VIX and the SPX became positively correlated, the broad market subsequently suffered a setback (Chart 3).  While the SPX is making all-time highs, the VIX is neither making all-time lows nor cyclical lows. Importantly, equity market volatility is staying stubbornly close to 15, slightly below the ten-year average. As a reminder, a “VIX reading of 15 means that in 30 days the S&P 500 is expected to trade between 4.3% lower and 4.3% higher than its current level”.1 Chart 3Watch Out For Vol Watch Out For Vol Watch Out For Vol The extreme concentration in excess returns in a handful of tech stocks is another potential trouble spot for equities that we have been highlighting recently.2 Chart 4 shows the percentage of GICS2 sectors with negative two-year relative share price momentum. The higher this diffusion rises the fewer the sectors that drive the SPX’s return. Historically, when our diffusion hits the 70% mark, it signals exhaustion in equity market returns. In fact, 70% readings in this diffusion indicator led both the 2000 and 2007 peaks in the SPX. Chart 4Heed The Diffusion Index’s Message Heed The Diffusion Index’s Message Heed The Diffusion Index’s Message This week we update our views on the cyclical /defensive portfolio bent and a niche industrials sub-group. Meanwhile on the economic front, the JOLTS report made for grim reading. Labor market softness was evident across the board and it was not squarely concentrated in the manufacturing sector. While this indicator only goes back two cycles, it is flashing yellow for the prospects of the broad equity market (top panel, Chart 5). Importantly, we will continue to monitor the job openings numbers as they are sending the exact opposite signal compared with unemployment insurance claims (job openings shown inverted, middle & bottom panels, Chart 5).  This week we update our views on the cyclical /defensive portfolio bent and a niche industrials sub-group. Chart 5Avoid Getting JOLTed Avoid Getting JOLTed Avoid Getting JOLTed Mixed Signals We have been neutral the cyclicals/defensives ratio for the past 8 months and continue to recommend investors stay on the sidelines for a while longer. It has been particularly difficult to distinguish a clear signal from noise lately for the cyclicals versus defensives ratio. Relevant macro drivers, operating metrics and profit fundamentals, valuations and technicals all have been emitting conflicting messages and the recent coronavirus epidemic will likely make the waters murkier still. US Equity Strategy’s Global Trade Activity Indicator has turned south recently following in the footsteps of the Chinese manufacturing PMI data that ticked down and are slated to drop below the boom/bust line in the current month (top & bottom panels, Chart 6). The bond market also reflects a gloomy global economic backdrop with the global 10-year Treasury yield sinking like a stone. Such a lackluster bond market will likely weigh on relative share prices (middle panel, Chart 6). CEOs remain a depressed bunch and it is all but certain that for, at least, the next three months executives will put capex plans on the backburner. Basic resources are most at risk and keep in mind that relative capex growth was already decelerating prior to the coronavirus epidemic (top & second panels, Chart 7). Chart 6Trade Uncertainty… Trade Uncertainty… Trade Uncertainty… Chart 7… And Capex Softness Weighs On Cyclicals … And Capex Softness Weighs On Cyclicals … And Capex Softness Weighs On Cyclicals A soft sales backdrop coupled with inventory accumulation are firing a warning shot. Relative share prices will likely succumb to the still weak total business sales-to-inventories ratio (third panel, Chart 7). Importantly, an inventory liquidation phase will continue to exert downward pressure on relative profit margins (bottom panel, Chart 7). Chart 8Pricing Power Proxy Blues Pricing Power Proxy Blues Pricing Power Proxy Blues Our simple relative pricing power proxy for the cyclical/defensive ratio best encapsulates these relative selling price pressures. The CRB metals-to-gold price ratio is on the verge of a breakdown and warns that the wide gulf that has opened up between our pricing power proxy and relative share prices will narrow via a sell off in the latter (Chart 8). Nevertheless, this stands in marked contrast to the ISM manufacturing prices paid subcomponent of the Report On Business survey and actual cyclicals/defensives pricing power momentum (bottom panel, Chart 9). Chart 9The US Dollar Holds The Key The US Dollar Holds The Key The US Dollar Holds The Key Were the greenback to depreciate in the coming months as our FX strategists expect, then cyclicals selling prices would definitively regain the upper hand versus their defensives counterparts (top & middle panels, Chart 9). But, the jury is still out. Sell-side analysts remain optimistic that relative profits will stage a significant comeback in the next year, but on a short-term basis have been trimming cyclical versus defensive earnings revisions (middle & bottom panels, Chart 10). While our macro-factor relative profit growth models were staging a comeback all last year, they ticked down last month (second panel, Chart 10). Finally, relative technical and valuation conditions are both tracing out a bottom near the one standard deviation below the historical mean, a level that has marked prior recoveries in relative share prices (Chart 11). Chart 10Mixed Bag Mixed Bag Mixed Bag Chart 11Unloved & Undervalued Unloved & Undervalued Unloved & Undervalued Bottom Line: Most of the macro and operating indicators we track are sending conflicting messages on the anticipated direction in the cyclical/defensive ratio. Remain on the sidelines on cyclicals versus defensives, but stay tuned. Clipped Wings? Airline stocks have taken it to the chin lately on the back of coronavirus demand destruction fears, but we reiterate our overweight stance as extreme bearishness appears overdone. Investors tend to overreact to events such as virus epidemics, but we deem that such fears typically create trading opportunities, especially in the hardest-hit sectors. Similar to hotels (that we upgraded to neutral last week), airlines are part of the tourism-related industries that have suffered disproportionately. Were we not overweight the S&P airlines index, we would not hesitate to initiate such a position. True, consumer and business demand for air transportation services will come under pressure in the near-term, however looking further out such demand destruction will likely prove transitory. Chart 12 shows that the cyclical demand backdrop is robust for the US airline industry. Overall consumer outlays jumped recently, PCE services momentum is perking up, airfare PCE is outpacing overall consumer spending – an impressive feat – and consumer confidence is perched near cycle highs sustaining a wide gap with relative share prices (bottom panel, Chart 12). US domestic and international passenger enplanements are running near the 5%/annum growth rate and the recent rebound in the global and US services PMIs suggests that any kink in demand will likely prove short-lived (Chart 13). Chart 12Firming Cyclical… Firming Cyclical… Firming Cyclical… Chart 13…Demand Backdrop… …Demand Backdrop… …Demand Backdrop… Importantly, this firm cyclical demand backdrop is reflected in accelerating airline selling price inflation both on domestic and international routes (second & third panels, Chart 14). However, profit margins have yet to reflect this encouraging top line growth backdrop. The airline load factor spread (calculated as load factor minus break-even load factor) also heralds a profit margin expansion phase (bottom panel, Chart 14). Chart 14…Is A Boon For Selling Prices …Is A Boon For Selling Prices …Is A Boon For Selling Prices Chart 15Lower Fuel Costs Should Turbocharge Profit Margins Lower Fuel Costs Should Turbocharge Profit Margins Lower Fuel Costs Should Turbocharge Profit Margins Tack on the roughly 16% year-to-date drubbing in oil prices and airline profit margins will expand in 2020. This is true especially for the bulk of the industry that does not hedge kerosene costs (jet fuel shown inverted, Chart 15). The analyst community has been pessimistic about the prospects of airline stocks. Revenue and profit growth expectations are slated to tail the SPX in the coming twelve months. This sets a low bar for the industry to surpass in coming earnings seasons (Chart 16). Finally, investors have thrown in the towel, pushing relative valuations to extremely depressed levels to the tune of nearly two standard deviations below the historical mean (middle panel, Chart 17). Relative technicals are also washed out and signal that, at least, a reflex rebound is in store in the coming months (bottom panel, Chart 17). Chart 16Low Bar To Surpass Low Bar To Surpass Low Bar To Surpass Chart 17Contrary Alert: Pessimism Reigns Supreme Contrary Alert: Pessimism Reigns Supreme Contrary Alert: Pessimism Reigns Supreme In sum, while the coronavirus epidemic will take a bite out of airline demand in the near-term, firm consumer confidence, rising consumer outlays, recovering services PMIs, rising airline pricing power, falling kerosene prices, compelling relative valuations and oversold technicals, all signal that airlines are well positioned to regain altitude on a cyclical time horizon.      Bottom Line: Stay overweight the S&P airlines index. The ticker symbols for the stocks in this index are: BLBG S5AIRLX – LUV, DAL, UAL, AAL, ALK.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com       Footnotes 1     https://us.spindices.com/vix-intro/ 2     Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios”, dated January 13, 2020, and “When The Music Stops…”, dated January 27, 2020, both available at uses.bcaresearch.com. Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Will The Fed Save The Day, Again? Will The Fed Save The Day, Again? Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth May 10, 2018 Favor large over small caps (Stop 10%) June 11, 2018 Long the BCA  Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).

Cyclical Wounds Remain Open Cyclical Wounds Remain Open Neutral - Downgrade Alert The transportation industry is a bellwether for the economy as rising freight hauling services demand is synonymous with firming economic activity and vice versa. The recent FedEx earnings report raised red flags both for the wellbeing of the transport sector (second panel) and the U.S. economy, especially the highly cyclical manufacturing sector. The company blamed soft global macro conditions and significantly trimmed profit guidance for its fiscal year. FedEX also highlighted that the absence of a trade deal with China complicates the free movement of goods (bottom panel) and the longer the uncertainty between the U.S. and China remains in place, the longer it will take for global trade growth to heal. One saving grace for air freight stocks has been the industry’s pricing power rebound, but there are mushrooming signs that sector inflation will cool down in the coming months (third panel). We have been neutral on the S&P air freight & logistics index since removing it from our high-conviction overweight list following previous FedEx profit warning, and now we are putting this transportation subgroup and the overall transportation index on our downgrade watchlist. Bottom Line: We are neutral the S&P transportation index, but now have it on downgrade alert. Our barbell strategy within transports remains in place overweighting airlines, neutral on air freight & logistics (but it is now on downgrade alert) and underweighting rails. Stay tuned. ​​​​​​​

Stick With Airlines For Now Stick With Airlines For Now Overweight-Downgrade Alert Airline stocks bounced off a critical support level on the back of encouraging profit results (top panel). Lower kerosene prices especially for the non-hedged carriers are flowing straight to the bottom line and a busy travel season signals additional gains in the coming months (jet fuel shown inverted, second panel). Not only domestic, but also international airfares are rebounding smartly and signal more revenue growth for airline stocks despite the grounding of the 737 MAX jet likely into 2020 (third panel). Sell side analysts have taken notice and the industry’s net EPS revisions ratio is on a slingshot recovery. While we continue to avoid rails (see the recent Insight) and remain neutral on airfreight & logistics, airlines are a positive exception within transports.   Bottom Line: Stick with an above benchmark allocation in the S&P airlines index, but stay tuned. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, UAL, AAL and ALK.

Overweight (Downgrade Alert) When we moved to an overweight recommendation on the S&P airlines index in the fall of last year, we noted three pillars supporting the onset of an earnings outperformance: a drubbing in oil prices significantly lowered the key input cost while rebounding consumer spending supported higher ticket prices and soaring consumer confidence encouraged expanding volumes.  The latter two of these pillars remain robust (third and bottom panels) while the former has given up much of its benefit (jet fuel shown inverted, second panel).  Intense Competition Hurts Airlines Intense Competition Hurts Airlines We had further noted that the major carriers had shelved plans to expand their domestic capacity which reduced the risk of a profit-destroying fare war. However, news reports have been highlighting intensifying competition on the key domestic transcontinental market, driven by excess capacity being deployed by all major transcon carriers. The Wall Street Journal reported this week that the premium cabin on these routes was selling for as little as 20% of the transatlantic fare. While passengers should be celebrating, investors should take a much dimmer view of this level of discounting. Bottom Line: Though consumer confidence remains near all-time highs, rising fuel prices and fare competition could put our S&P airlines relative earnings outperformance thesis offside. We are adding a downgrade alert to our overweight recommendation today. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, UAL, AAL and ALK.    

Airline Demand Is Soaring Airline Demand Is Soaring Overweight With a pickup in oil prices in general and jet fuel prices in particular, a logical inference would be a decline in airlines’ earnings power (second panel). However, the revenue side of the equation has proven much more resilient than anticipated, a result of industry discipline reflected in constrained capacity growth combined with elevated consumer confidence. The upshot is that consumers have been willing to part with greater shares of their wallets in order to fly (third panel). Much of this is reflected in Delta’s results yesterday. The company lifted their full-year guidance on the back of outstanding customer demand driving unit revenues higher, combined with single-digit capacity growth. While it is worth cautioning that DAL does not face the same 737 MAX grounding issues as peers LUV, UAL and AAL, we believe the exceptional fare environment is a tide that lifts all boats. Accordingly, we expect earnings in the S&P airlines index to continue to significantly outpace the broad market (bottom panel), particularly once the transitory 737 MAX grounding issue is resolved. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, UAL, AAL and ALK.   ​​​​​​​

  Overweight The Q4 earnings season has become dramatic in the airlines sector as the S&P airlines index is fairly evenly split with positivity and negativity. On the positive front, both LUV and AAL delivered guidance ahead of estimates, the former dramatically so. However, DAL and UAL cautioned that the upcoming quarter would be challenged by the federal shutdown and a partial shift of Easter from Q1 to Q2. Net, airline stocks have recovered to where they started the year. We remain airline bulls; early guidance is pointing to the high capacity growth of 2018 subsiding this year, leaving us encouraged about the fare environment. On the cost side, jet fuel (the greatest driver of airline profitability) has fallen from last year’s levels and further reprieve will be a boon to earnings (second panel). The sell-side has clearly noticed these tailwinds and the differential vis-à-vis the broad market in earnings expectations has now reached into double-digits (bottom panel). Bottom Line: Revenue growth seems solid in airlines and, assuming cooperative input costs, profitability should handily beat the broad market; stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, UAL, AAL and ALK. Ready For Takeoff Ready For Takeoff