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5 July 2016 · 5 min read

Can aerospace & defence weather Brexit

Impact of lower GDP growth on the aerospace & defence industry

I am a firm believer that GDP growth is the most important driver behind the health of the aerospace & defence sector. A strong economy increases people’s propensity to travel, and defence budgets are set as a percentage of GDP. I acknowledge that the two sides of the sector are both affected by a number of other factors (the oil price, new technologies, geopolitical tensions, etc) and both industries are global. However, the Treasury’s projection that in two years’ time UK GDP will be 3.6% lower than if we had remained in the EU forces me to pause for thought as to the possible impact of Brexit on the sector over the long term.

There are many unknowns in our post-Brexit world and there are no clear answers yet as to how aerospace & defence companies will cope with the practicalities of leaving the EU. For example; will Airbus still make its wings in Broughton? How will terms of trade alter for Rolls-Royce when selling engines to Airbus or European airlines? Will BAE be able to participate in future European defence collaborations? What will Safran, Thales and Finmeccanica do with their UK sites? While I acknowledge that it is likely to be a bumpy ride, I am confident that the management teams are capable of finding solutions to these and many other logistical challenges.

Unfortunately, though, there is little that management teams can do to protect against the impact from an ‘immediate and profound economic shock’  which is how the Treasury, the Bank of England and the IMF are describing Brexit. The chart below shows that periods of increased uncertainty have been associated with lower GDP growth and it is already clear that the next two years will be a minefield of uncertainty while Britain negotiates its exit from the EU.

Chart 1: UK GDP growth and uncertainty (HM Treasury)

HM Treasury’s worst-case scenario is that in two years time UK GDP could be 6% lower. It is also worth noting that the impact of Brexit is expected to be a permanent downward shift in the level of GDP, not a temporary impact that is recovered after a period of time.

IATA has therefore adjusted its projections for passenger growth because the elasticity between income (proxied by GDP) and air travel demand is consistently positive and greater than 1, as shown in the chart below.

Chart 2: IATA UK PAX v GDP growth (IATA)

The UK air passenger market is now expected to be 3-5% lower by 2020 than if we had remained in the EU . The chart below shows the impact on GDP and air passenger numbers of previous economic shocks: the UK’s decision to exit the European Exchange Rate Mechanism (ERM) in the early 1990s and the global financial crisis in 2009 (GFC). The expected Brexit GDP shock is comparable to that which followed the ERM exit, but IATA expects the recovery following Brexit to be “longer and shallower”. There are two drivers behind the record-breaking backlog at Airbus and Boeing: rising passenger numbers in Asia and the demand for more fuel-efficient aircraft in the US and Europe. It is therefore reasonable to assume that the order book is afforded some protection from the impact of Brexit, as was the case in the 2009 financial crisis. However, we should not dismiss the possibility that a vote to leave the EU could have knock-on effects for the global economy. HM Treasury is currently modelling a reduction in euro area GDP of around 1% by 2018 and so the OEMs will have to continue to manage their delivery schedules cleverly to prevent disruption to production if Airlines are unwilling or unable to honour their orders.

Chart 3: Impact of recession on UK passenger traffic growth (IATA)

The link between GDP and defence budgets was made very clear in the 2015 Strategic Defence and Security Review (SDSR).

“Our national security depends on our economic security, and vice versa. So the first step in our National Security Strategy is to ensure our economy is, and remains strong…our strong economy provides the foundation to invest in our security and enable us to project our influence across the world. It has enabled us to choose to invest 2% of GDP on Defence”.

Given that Brexit has now changed the outlook for UK GDP, it is logical to assume that the next Prime Minister will have good reason to demand a new SDSR take place in order to reassess priorities. It is likely that this would begin in autumn 2016 and be concluded by spring/summer of 2017, and could well require further cuts from the procurement budget. For many UK defence and security companies, the US and export markets are much more important than the UK. However, it is important to acknowledge that lower UK GDP could force a re-evaluation of UK defence procurement, and thus alter the operating environment in the domestic market over the next decade.

The defence industry is familiar with operating in a contracting end-market. However, civil aerospace has enjoyed a seven-year period of mostly unfettered growth in passenger traffic. The challenge for the companies is whether they can alter their cost bases dynamically to protect earnings in what is likely to be a more challenging economic environment. Investors will be scrutinising the next round of outlook statements and keeping a close eye on the Boeing and Airbus order book for increases in the level of cancellations. 


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