Terminal conditions

Air travel’s sudden collapse will reshape a trillion-dollar industry

The pandemic has knocked the airline-industrial complex harder than it has most sectors




Like most international jamborees these days the Farnborough air show wrapped up on July 24th as a virtual event. Webinars featuring grim-faced executives were not as entertaining as noisy acrobatic displays by fighter jets.

But commercial aviation’s most important showcase at least marked a point when heads began to turn away from the devastation wrought by covid-19 and towards what comes next.

As airlines sell fewer tickets, owing to pandemic travel restrictions or travellers’ fear of infection, the industry that makes flying possible faces a reckoning. Aircraft-makers will make fewer passenger jets and so need fewer parts from their suppliers. Ticket-sellers will see less custom and airport operators, lower footfall. Many firms have cut output and laid off thousands of workers. The question now is how far they will fall, how quickly they can recover, and what will be the long-lasting effects.


The airline-industrial complex is vast. Last year 4.5bn passengers buckled up for take-off. Over 100,000 commercial flights a day filled the skies. These journeys supported 10m jobs directly, according to the Air Transport Action Group, a trade body: 6m at airports, including staff of shops and cafés, luggage handlers, cooks of in-flight meals and the like; 2.7m airline workers; and 1.2m people in planemaking.

In 2019 they helped generate revenues of $170bn for the world’s airports and $838bn for airlines. Airbus and Boeing, the duopoly atop the aircraft supply chain, had sales of $100bn between them. For the aerospace industry as a whole they were perhaps $600bn. Add travel firms like Booking Holdings, Expedia and Trip.com, and you get annual revenues of some $1.3trn in normal times for listed firms alone, supporting roughly as much in market capitalisation before covid-19—and rising.

Taxiing times

Instead, the coronavirus has lopped $460bn from this market value (see chart 1). Airline bosses are reassessing trends in passenger numbers, which had been expected to double in the next 15 years, just as they had with metronomic regularity since 1988, despite blips after the 9/11 terrorist attacks of 2001 and the financial crisis of 2007-09. Rather than increase by 4% this year, air-transport revenues will fall by 50%, to $419bn.

After ten years of unusual profitability the $100bn of total losses forecast for the next two years is equal to half the nominal net profits the industry raked in since the second world war, calculates Aviation Strategy, a consultancy. Luis Felipe de Oliveira, director-general of aci World, which represents the world’s airports, gloomily predicts that revenues there will fall by 57% in 2020.



Despite signs of life, particularly on domestic routes in large markets like America, Europe and China, the outlook remains uncertain. The wide-body jets used for long-haul flights stand idle. Carriers that rely on business passengers and hub airports are struggling. Although some American airlines expect a return to near-full operation next year, a second wave of covid-19 could dash these hopes. A small outbreak in Beijing in June set back the recovery in Chinese domestic flights. As one senior aerospace executive says, “It’s hardest to talk about the next 12 months.”

According to Cirium, another consultancy, around 35% of the global fleet of around 25,000 aircraft is still parked—less than the two-thirds at the height of the crisis in April but still terrible. Even if traffic recovers to 80% of last year’s levels in 2021, as some optimists expect, plenty of aeroplanes will remain on the ground. Citigroup, a bank, forecasts excess capacity of 4,000 aircraft in 18 months’ time.

Aircraft-makers, which had been preparing to crank up production, are forced to do the opposite. Airbus, with a backlog of more than 6,100 orders for its a320 jets, was rumoured to be raising output from 60 of the popular narrow-bodies a month to 70. Instead it is making 40. Its long-haul planes have suffered similar declines.

Boeing’s situation is made worse by the protracted grounding in 2019 of its 737 max, a rival to the a320, in the wake of two fatal crashes. It has kept making the aircraft and hopes to have it recertified for flight later this year. The American firm will slowly increase production to 31 a month by the start of 2022. But like Airbus, it too has announced cuts to wide-body production.

This will open a big gap between what the pair, along with Embraer and Bombardier, makers of smaller regional jets, hoped to sell and what they actually will (see chart 2). According to consultants at Oliver Wyman, by 2030 the global fleet will be 12% smaller than if growth had continued unabated. That amounts to 4,700 fewer planes, which could translate to $300bn or so in forgone revenue for Boeing and Airbus, according to a rough calculation by The Economist.




With so many aircraft sitting idle and balance-sheets in tatters, airlines are getting rid of planes. Even low fuel prices will not save older, thirstier models. Four-engine wide-bodies are all but finished. On July 17th British Airways (ba) said it would retire all 31 of its Boeing 747 jumbo jets. iba, an aviation-research firm, expects 800 planes around the world to be retired early.

Not all orders will dry up. Airlines, as well as leasing firms, which now own close to half the global fleet, are contractually obliged to take aircraft on order. Many buyers will have made pre-delivery payments of up to 40% of the price. Airbus and Boeing are, to varying degrees, pushing customers to take deliveries.

Most negotiations have centred on deferring deliveries. EasyJet, a British low-cost carrier, has pushed back delivery of 24 Airbuses by five years. At Boeing, delays related to the problems of the 737 max allow airlines to ask for refunds. More assertively, Airbus’s boss, Guillaume Faury, does not rule out suing customers who renege on their orders.

A stock of “white tails”, as unsold planes are known in industry vernacular, may be the price to pay for protecting a supply chain that had been investing heavily for ever-higher production rates. Airbus will make 630 planes this year but deliver only 500, Citigroup reckons. It has the balance-sheet to carry inventory, thinks Sandy Morris of Jefferies, another bank. The new rate will preserve jobs and industrial efficiency, and make an eventual ramp-up easier.

Even this artificially high production will struggle to sustain the planemakers’ supply chain, however. This comprises manufacturers of engines (like Rolls-Royce and ge), producers of fuselages and other parts (such as Spirit AeroSystems), specialised materials firms (Hexcel and Woodward) and companies that produce avionics and electrical systems (including Honeywell and Safran). And that is not counting their myriad smaller suppliers; Boeing’s max supply chain stretches to around 600 firms.

Many had invested heavily before the crisis, expecting strong demand. Defence contracts, which firms from Airbus and Boeing down are involved in and which covid-19 has not really affected, provide only partial respite. On July 29th Boeing said it had delivered just 20 planes in the second quarter, down from 90 a year ago, and that commercial-aircraft revenues had dropped by 65%, to $1.6bn. The next day Airbus and Safran also disclosed sharp falls in revenue.

The engine-makers provide a case in point. Besides lower demand for their kit—Rolls-Royce was gearing up to supply 500 units a year to Airbus but will now probably make 250—they face a collapsing aftermarket for spares and fewer overhauls, points out David Stewart of Oliver Wyman. Airlines with in-house maintenance divisions can scavenge parts or whole engines from grounded planes.

Rolls-Royce, whose engines power two-fifths of all long-haul jets, has suspended dividends, said it would cut 9,000 jobs and taken a £2bn ($2.6bn) loan. It may have to ask investors for another £2bn. ge’s second-quarter revenues from its aviation business fell by 44%, year on year, dragging down the conglomerate’s overall results.

At the other end of the air-travel industry are airports. About 60% of their revenues comes from charges on airlines and passengers, and the rest from things like retail and parking. All are taking a hit. Airport shops and restaurants in America will lose $3.4bn between now and the end of 2021, forecasts the Airport Restaurant & Retail Association.

As Mr de Oliveira of aci World notes, two in three airports were losing money before the crisis; now all are. Some smaller ones may close if subsidies to support tourism from regional and national governments start to dwindle. Outside America commercial operators have not been treated by governments as generously as airlines have.

In July Standard & Poor’s again downgraded the debt of four European airports, including Amsterdam’s Schiphol and Zurich, and placed London Gatwick and Rome on watch, questioning their ability to raise charges while airlines continue to bleed cash. The rating agency estimates a cut of €10bn ($11.8bn) in planned capital spending by European airports in 2020-23, which may crimp efforts to install contactless technology that could help reassure travellers that terminals are safe to re-enter.

As dark as the skies have grown for the air-travel complex, there are some opportunities. Airlines are restructuring. Europe’s big legacy carriers, under pressure from low-cost rivals, are slashing costs. ba has suspended 30,000 workers and wants to rehire them on less generous terms. Bankruptcies and cutbacks will leave gaps in the market, aircraft are cheap, once-scarce pilots are plentiful, and airports will have spare slots, if they are allowed to redistribute them.

Strong challenger carriers have a chance to gain market share. Wizz Air, a Hungarian low-cost carrier, hopes to add capacity by March; its main markets in central and eastern Europe have been hurt less by the pandemic than those elsewhere, its customers are generally young and less worried about getting on a plane, and two-thirds of demand is related to visiting family and friends, which seems more resilient to covid-19 than business travel is.

Some carriers may radically rethink their financial structures, which could help leasing grow even faster. Domhnal Slattery, boss of Avolon, a big lessor, thinks that heavy debts airlines incur to survive the pandemic may convince many of them that they need not own aircraft but should instead concentrate on sales and marketing, just as hotel chains have turned their backs on owning property.

The industry is also rethinking its environmental footprint. Bolder airlines with stronger balance-sheets may use the crisis to renew their fleets, making them greener. They have bargaining power: everything is negotiable, including deferrals, prepayments and price.

Rolling with the punches

Warren East, boss of Rolls-Royce, suspects that the “pre-covid call for sustainability will come back stronger than ever”. Airbus is still committed to the journey to zero-emissions flying, Mr Faury says; he sees it as an opportunity. Boeing would have to respond to stay competitive. European governments in particular regard it as a priority.

France’s €15bn aid package for its aerospace sector includes a €1.5bn research-and-development fund to help Airbus launch a zero-emissions short-haul passenger jet by 2035 (probably powered by either biofuels or hydrogen). Mr Faury accepts that there is less money to invest.

But also, he says, “more need”. The crisis has led to greater collaboration with suppliers that could make innovation “faster, leaner and cheaper” (though that has meant laying off 15,000 workers).

China, desperate to become a power in commercial aerospace, may see the disruption as a way to speed up entry into the global market, says Robert Spingarn of Credit Suisse, a bank. He speculates that Brazil’s Embraer, whose merger with Boeing fell apart in April, might collaborate with China’s comac to build a plane capable of competing against Airbus and Boeing. The Brazilians could supply the industrial knowhow and the Chinese the industrial might.


To the masked passengers on half-empty planes, boarded from ghost-town airports of shuttered shops, it may seem that the experience of flying will never be the same again. Yet aviation has bounced back before. It is likely to do so again—and may change for the better in the process. ■

How to cope with middle age

Google has outgrown its corporate culture

It is time to learn from its elders



It may be just 21 years old, but Google is in the midst of a mid-life crisis. As so often in such cases, all seems well on the surface. Every day its search engine handles 6bn requests, YouTube receives 49 years’ worth of video uploads and Gmail processes about 100bn emails. Thanks to its dominance of online advertising, Google’s parent company, Alphabet, made a profit of $34bn last year.

Beyond its core operations, it is a world leader in artificial intelligence (AI), quantum computing and self-driving cars. Along with the bosses of Amazon, Apple and Facebook, its chief executive, Sundar Pichai, was grilled this week by lawmakers in Washington, DC, who fret that America’s tech giants need to be restrained because they are so profitable. Crisis? What crisis?

Being hauled before Congress is, on the face of it, a sign of success. But it also marks a difficult moment for Google’s leaders: the onset of corporate middle age. This is a problem as old as business itself. How do companies sustain the creativity and agility that made them great, even as they forge a culture and corporate machine that is built to last?

For Google the transition is especially dramatic because its founders, Larry Page and Sergey Brin, tried from the start to build a firm in which this moment would never arrive. As Google prepared to go public in 2004 they declared that it was not a conventional company, and “we do not intend to become one”.

They hoped playground-like offices, generous perks and a campus atmosphere would allow it to retain the agility and innovation of a startup as it grew. The appearance of wrinkles on the corporate forehead is an admission of failure.

The signs of ageing are apparent in Google’s maturing business, its changing culture and its ever-more-entwined relationship with government. Take the business first. The firm is running up against growth constraints in its near-monopolies of search and online-advertising tools. Its market share in search ads is around 90%.

Unearthing other gold mines has proved difficult. None of the ambitious “moonshot” projects into which Alphabet has poured billions, such as delivery drones and robots, has been a breakout success. To keep growing, Google is having to try to muscle in on the turf occupied by big tech rivals, such as cloud computing and enterprise software and services.

The cultural challenge is fuzzier but no less urgent for a firm that is proud of its unusual corporate character. The freewheeling ethos that was so successful in Google’s early days has become a liability. It works much less well at scale. Google now has nearly 120,000 employees, and even more temporary contractors.

Doing things from the bottom up has become harder as the workforce has grown larger and less like-minded, with squabbles breaking out over everything from gender politics and the serving of meat in cafeterias to Google’s sale of technology to police forces.

The third sign of lost youth, the attention of trustbusters, has long looked inevitable. As big tech has grown, so have its interactions with government—as an institution to lobby, as a customer and as a regulator. America’s Justice Department is poring over Google’s online-ads businesses and may soon file an antitrust suit. Scrutiny is unlikely to wane as the tech titans break out of their silos and compete more. Indeed, regulators may take it as a sign of broadening power.

How should Google respond? To be both innovative and mature is a hard trick to pull off. History is littered with failed attempts. In giving it a go, the firm has to decide whom it puts its faith in: managers, investors or geeks?

The first route would involve taking a strong dose of managerial medicine to become a more tightly run conglomerate. The archetype for this approach is ge in its heyday under Jack Welch, who persuaded shareholders that sprawling businesses could work well, provided they were run by expert managers.


But it turned out that ge was disguising weaknesses in its industrial units by leaning on its financial arm, ge Capital. ge’s subsequent woes offer a warning of the peril of relying on one hugely successful division to subsidise less profitable units elsewhere—as Google does with its advertising business.

If doubling down on the conglomerate model is not the answer, what about the opposite approach: spinning off, selling or closing some units and returning money to shareholders? That would please many investors. By some calculations, Alphabet is worth $100bn less than the sum of its parts. Spinning off YouTube would increase competition in internet advertising—a handy sop to regulators—as well as unlocking value.

It might be worth more than Netflix, because it need not pay for content, most of which is user-generated. But the experiences of firms like at&t and ibm highlight the danger that downsizing hollows out innovation. And while Google might hope to retain its distinctive culture in whittled-down form, the truth is that no matter how much it wants to be as youthful and free-spirited as Peter Pan, it is no longer a startup.

That leaves trusting the geeks. Becoming a glorified venture-capital outfit has appeal, but the woes of SoftBank’s Vision Fund warn of hubris. Google would do better to examine how two older tech giants overcame their own mid-life crises (and near-death experiences): Microsoft, nearly broken up by antitrust regulators, and Apple, which spent years in the wilderness before Steve Jobs returned to reinvent it as a maker of portable devices.

Both bounced back by rediscovering their core purpose and applying it in a new way. Under Satya Nadella, Microsoft has reinvented itself as a provider of cloud-based software tools and services, rather than its Windows operating system. And Apple, previously known for its elegant, easy-to-use computers, has minted money by applying its genius to smartphones.

Could Google similarly identify what it does best and apply it in new areas? It could decide its mission is helping consumers trade their personal data for goods and services; or using ai to solve more of the world’s problems; or being the data processor of net-enabled gadgets. At the moment it is betting on almost everything.

Indiscipline can lead to unexpected innovations, but more often saps vitality. Google’s best way forward is to follow the advice often given to victims of a mid-life crisis: slim down, decide what matters and follow the dream.

The path from Covid-19 to a new social contract

Pandemic offers world leaders an opportunity to rebuild faith in liberal democracy

Philip Stephens

Ingram Pinn illustration of Philip Stephens column ‘The path from Covid-19 to a new social contract’
© Ingram Pinn/Financial Times



To employ an old world metaphor, entire forests have been felled in the cause of predicting how Covid-19 will change the planet. This before anyone knows if, five years from now, we will still be hiding from the virus or whether it will have been consigned to the epidemiological textbooks by an effective vaccine.

The heavy first-round costs, human and economic, speak for themselves. They need to be measured against the options that are opening up for policymakers. Left to itself, the pandemic could tip many of the world's rich democracies over the populist edge on which they have been teetering since the 2008 financial crash. Paradoxically, it also offers a route for political leaders to rebuild faith in liberal democracy.

There is no mystery about the populism that saw Americans vote for Donald Trump as president, Britain to back Brexit and voters across Europe to flock to parties of the far-right and left. The stability of the postwar ancien régime rested on a social contract that underwrote steady rises in living standards.

This varied among nations, was far from perfect and never universal, but its legitimacy was rooted in a broad perception of “fairness”. Successive generations could expect to be more prosperous than the last.

Trust collapsed with the 2008 crash and the austerity-induced recession that followed. The fracturing of the contract, however, had started much earlier with stagnant median incomes, rising job insecurity and widening income inequalities.

Low-income, unskilled workers were left behind by technology, rapid shifts in comparative advantage and the slavish devotion to unfettered markets of policymakers mesmerised by something called the Washington consensus.

Once things went badly wrong, populists had only to serve up a smorgasbord of enemies — the old political elites, bankers and minimum-wage immigrants. When voters stopped believing their children were assured of a better future, they also concluded they had nothing to lose. It scarcely mattered that the likes of Mr Trump and Britain's prime minister Boris Johnson were themselves creatures of the elites.

Coronavirus has shaken the kaleidoscope. If policymakers do nothing much, the effect will be to widen the inequality gap still further. The biggest losers so far have been workers in the low-paid, insecure jobs of the gig economy. They will also bear the brunt if governments respond to the huge increases in fiscal deficits by cutting back on future public spending.

The pandemic, however, has also changed the political argument. Competence and fairness have returned to the top of the hierarchy of things that citizens look for in their leaders. The crisis has reframed the role of the state, and, importantly, put a premium on trust.

To adapt a remark once made by Britain's Margaret Thatcher, citizens have been reminded that there is such a thing as society, and that effective government provides the essential glue.

It is no accident that the US, Brazil and Britain have all fared so badly in responding to the pandemic. Messrs Trump and Johnson, and President Jair Bolsonaro in Brazil, have learnt that bluff and bluster are no guard against a deadly virus. They have all seen their ratings fall sharply as death rates have risen.

If, as the polls suggest is likely, Mr Trump loses November's presidential election, it will be in significant part because voters know that building a wall along the Mexican border is no protection from coronavirus.

None of this is to say that mainstream leaders have an easy task. The short-term economic outlook is worse than bleak — a deep recession, sharp increases in unemployment and massive fiscal deficits.

The big change, though, is that the shift in the public mood has given them the political space to mark out a different direction. It is no longer quite so obvious that the answer to every economic policy dilemma is to let markets decide, cut taxes on the wealthy and rig labour markets against the low-paid.

There is no need to reinvent the wheel. Politicians sometimes pretend that the things that drove voters into the arms of populism were unavoidable consequences of globalisation and technological change.

In truth, they also reflected the choices made by governments when setting tax, spending and competition policies and dismantling labour standards. To the extent that globalisation produced so many losers, it was because national policies were pushing in the same direction.

A new social contract would start with policies to reward enterprise but punish rent-seeking, shift the burden of tax away from income and towards accumulated capital and establish job and income protections to boost productivity.

Measures to cut fiscal deficits cannot be at the expense of education and training strategies to fit changing demands for skills. We all pay a price for low wages and zero-hours contracts.

Populists have prospered by exposing real grievances. The left-behinds were not an invention.

The pandemic has changed the calculus by demonstrating that the supposed remedies peddled by Mr Trump and his ilk were snake oil. There is no easy way back from the effects of coronavirus, but it has pressed the reset button.

Leaders prepared to offer competence and fairness — a new social contract — have an audience again. It is not an opportunity they can afford to waste.

China Plays the Iran Card

A recently announced partnership accord between China and Iran will have far-reaching strategic implications in the Middle East and South Asia. As much as Americans would like to withdraw from these regions once and for all, the fact is that the US rivalry with China will be a global affair.

Vali Nasr, Ariane Tabatabai

nasr2_Noel Celis - PoolGetty Images_china iran

WASHINGTON, DC – Earlier this month, Iran announced that it is negotiating a 25-year agreement with China encompassing trade, energy, infrastructure, telecommunications, and even military cooperation.

For Iran, the prospect of a strategic partnership with China comes at a critical time. The Iranian government has been confronting popular discontent over a sinking domestic economy, which has been battered by American sanctions and, now, COVID-19.

Making matters worse, a recent series of explosions across the country has deepened the sense that the regime is under siege. Damaging at least two sites associated with the Iranian nuclear and missile programs, these incidents appear to be part of a broader strategy by the United States and Israel to cripple Iran’s capabilities.

News of a large deal with China is thus a welcome diversion for the Iranian government, and may even buy it time to maintain the status quo until the November 2020 US presidential election. The outcome of that contest will determine the trajectory of US-Iranian relations and the fate of the 2015 Iran nuclear deal, known as the Joint Comprehensive Plan of Action (JCPOA), while also influencing Iran’s own presidential election in June 2021.

To be sure, Iranians historically have been averse to aligning too closely with any great power, and they are even less willing to accept economic tutelage. With Iran’s relationship with China already a source of domestic controversy, it is possible that the country’s parliament will refuse to ratify the deal unless it is revised to meet certain concerns.

But Iran’s economy has been in free-fall since 2018, when the Trump administration withdrew from the JCPOA and launched its “maximum pressure” campaign of heavy sanctions designed to squeeze the regime. Moreover, with the regime as a whole facing a public backlash, Iranian President Hassan Rouhani’s government has been under tremendous internal pressure.

The announcement of a deal with China allows Rouhani’s government to demonstrate that it is not putting all its eggs in the Western basket. The message to the Iranian people is they are not isolated, and may even enjoy economic improvements despite US sanctions.

At the international level, Iran has always sought to balance one great power against another. Over the past decade, in response to US diplomatic and economic pressure, its security forces looked to Russia, key economic sectors looked to China, and the Rouhani government reached out to Europe.

Now, with Sino-American tensions rising, Iran is looking to China to shore up its economy and balance the US. Closer ties with China would give Iran more leverage in future talks with the US and Europe when it comes to revising or restoring the JCPOA, as well as in its dealings with regional rivals such as Saudi Arabia and the United Arab Emirates.

By contrast, a strategic partnership with Iran is a minefield for China. Although China continues to trade with Iran and invest in the country’s infrastructure, a deepening of ties could raise America’s ire at a critical and increasingly sensitive diplomatic juncture.

By potentially exposing itself to US sanctions, China risks losing some access to the US market (which is far larger than that of Iran). Not surprisingly, Chinese officials have been relatively quieter about the negotiations than their Iranian counterparts have been. Likewise, China does not want to upset its regional partnerships with Israel or Saudi Arabia, each of which is currently engaged in proxy wars with and covert operations against Iran.

Nonetheless, China obviously sees some value in forging a comprehensive arrangement with Iran – a large, important regional player whose vast energy resources and tremendous economic potential make it a natural candidate for China’s westward-looking Belt and Road Initiative. China already buys discounted oil from Iran – not exactly a negligible benefit for the world’s foremost consumer of energy – and has become Iran’s key trading partner, including as a principal supplier of heavy machinery and manufacturing goods.

More broadly, China has steadily increased its interest in West Asia over the past decade. It is the chief sponsor of the regional Shanghai Cooperation Organization, and it has invested upwards of $57 billion in Pakistan. With the US set to leave Afghanistan, a partnership with Iran will give China a near-stranglehold over the strategic corridor stretching from Central Asia to the Arabian Sea.

As part of this expansion, China could even gain control of the Iranian port of Chahbahar, which its main Asian rival, India, has been developing in response to China’s development of the nearby Pakistani port of Gwador. The Chahbahar port allows India to circumvent Pakistan – another rival – in its trade with Central Asia.

But, despite the port’s recognized importance, US sanctions are forcing India out of Chahbahar and frustrating Iran. In fact, Iran is already reportedly forcing India out of a railway project that bypasses Pakistan to connect with Afghanistan and Central Asia. News of that rupture came just after China and Iran announced a preliminary deal.

The recent border skirmishes between China and India show just how seriously China takes its footprint in West Asia. In addition to opening the door for China to control Chahbahar and monopolize trade routes into Central Asia, the deal also appears to offer opportunities for China to develop naval facilities on the Gulf of Oman. Though the US has long wanted to shift away from the Middle East to focus more on China, the emerging Sino-Iranian deal reminds us that the two theaters are by no means separate.

By increasing pressure on both China and Iran, the US has encouraged the two countries to forge a common front. Though the Sino-Iranian a relationship is still a long way from becoming a new axis, the recent negotiations show that such an arrangement is possible.

American foreign policymakers should take note. The US will need to try placing a wedge between China and Iran, which requires deciding which one poses the greater threat. Americans may want nothing more than to leave the Middle East once and for all. But the fact is that the strategic competition with China will not play out only in East Asia.



Vali Nasr, Professor of Middle East Studies and International Affairs at Johns Hopkins University’s School of Advanced International Studies, is a former senior adviser in the US State Department and the author of The Dispensable Nation: American Foreign Policy in Retreat.

Ariane Tabatabai is a Middle East fellow at the Alliance for Securing Democracy at the German Marshall Fund of the United States and a senior research scholar at the Columbia University School of International and Public Affairs.


Yellow Flag Jobs Data

By John Mauldin


As I file this letter Friday morning, people are reacting to the July jobs report.

My own reaction: The headline report is absurd. I will explain further at the end of this letter. But first, I have another topic.

Regular readers know I worry about debt, mainly that the world has too much of it.
 
But it’s a little more nuanced. Whether debt is excessive depends largely on what it buys.

Debt is problematic when it underwrites unnecessary consumption. Going on vacation, for instance, is generally a bad idea if it saddles you with years of credit card payments. But debt helps when used to finance productive assets. This kind of debt should, if all goes well, generate enough new wealth to pay for itself and more.

In fact, the economy needs the second kind of debt to grow. Access to credit helps entrepreneurs start businesses that create jobs and offer innovative products. The challenge is to keep it under control. Lenders and borrowers both get overextended in good times and then overcompensate. The resulting cycle is one reason we have recessions.

And that’s where we are now: in a deep recession, and facing a depression.

We’ve already seen the savings rate climb to historic highs (with help from government stimulus). Now the second part is here as economically-critical credit begins drying up, sometimes even for stable, well-capitalized borrowers.

We don’t want banks getting into trouble that would require public bailouts.

But lower access to capital is a growing problem that will extend our economic agony, above and beyond the coronavirus and everything else.

Loss Exposure

Loan delinquencies and defaults rise when the economy weakens. That’s obvious—so obvious that, in theory, it shouldn’t happen. Everyone knows good times don’t last forever. The rational course is to borrow only if you are confident in your ability to repay when normal events (like recessions) happen.

That applies to lenders, too, and maybe even more so. They are in the business of taking credit risk. That’s why they can charge more than the risk-free interest rate. Their loan books should be prudently diversified and every borrower subject to strict credit analysis. Interest rates should be high enough to keep the lender stable even when normal events (like recessions) occur.

Last month’s bank earnings reports revealed the big lenders are sharply raising their loan-loss reserves. It is also happening in smaller Banks.


Source: The Wall Street Journal

 
These numbers still seem low to me, so I expect them to grow.
 
Nevertheless, they are already trickling through the economy at a noticeable pace.

Anecdote: I have a business associate (who asked not to be named) who has excellent credit. He monitors his FICO score and it’s always north of 800. He has several high-limit credit cards he rarely uses. In the last month, seemingly out of nowhere, three card issuers cut his limit to a paltry few thousand dollars.
 
That’s no loss to my friend, who wasn’t going to use the cards anyway. But what made the banks do this? It makes perfect sense from their perspective.

What the customer sees as “available credit” the bank sees as “loss exposure.” At any moment, my friend could have spent to his limit and then stopped making payments, maybe even going bankrupt and leaving the bank in a bad spot.
 
The bank normally accepts that possibility because it sees potential revenue, too. But now the risk outweighs the benefit so better to eliminate the possibility.

Actually, it makes sense. My friend is a lousy “customer.” Even though his credit is over-the-top, he is not making the bank any money. Without knowing, I can guarantee you the cards in question have low or no fees. Yet the bank has to reserve cash in case he decides to use them. Their actual reserves are being challenged, so he is an easy target.

I, on the other hand, don’t have his pristine credit. But I only have a few credit cards, which I used to charge everything possible, and then pay them off every month. It feeds my secret fetish: airline miles. So far, bank algorithms see me as a good customer who generates fees, and have not cut my credit line.

But he illustrates a point. If even highly rated, stable borrowers are seeing their limits cut, imagine what is happening to marginal borrowers.

We don’t have to imagine. We have actual data from the Federal Reserve’s quarterly Senior Loan Officer Opinion Survey.

US banks, and particularly the US branches of foreign banks, are tightening credit in most categories. It’s worse for small firms.

In fact, banks are tightening business loan standards at the fastest pace since 2008.


Source: Rosenberg Research

 
The Fed survey also found lower demand for all kinds of lending except residential real estate. I don’t know of any other business where it makes sense to raise the price of your product as demand for it drops.
 
That banks are doing so speaks to how nervous they must be. Worse, it’s happening despite massive Federal Reserve efforts to encourage and subsidize bank lending.

Stiff Drink Time

Whether it’s a bond or a bank loan, recovery potential is part of credit analysis. Defaults usually aren’t a 100% loss. What can we expect to get back if the borrower can’t repay? If you have collateral worth, say, 70% of the loan value, then you are taking less risk as the lender and can loan more freely.

Even better is to have the federal government standing behind a portion of the loan. That’s how Small Business Administration loans work. The SBA typically guarantees 50% to 85% of a loan amount, which lets banks offer more flexible terms than many small business owners could get on their own.

Keep in mind, many small businesses are struggling now but not all. Some have new opportunities in this environment. With capital, they could expand and maybe create jobs for the millions who need them. But they need the capital first.

Last week I read and reposted a Twitter thread (you should follow me, by the way) by someone describing himself as a consultant who helps franchisees get loans, often via SBA guarantees. I asked him to contact me and was able to verify his identity, though I can’t reveal it here. He described a terribly frustrating credit environment in his space. Below is a portion of his thread. (You can read the full version here.)

The banks I work with are SBA, conventional lenders who service smaller loans under 2mm and generally smaller operators of these franchise systems, and then larger banks who provide loans to larger operators from 2-50mm. I’m short—20+ banks across ALL spectrum of SME lending.

I fund 400-500mm in loans per year through these banks. In February we were on pace to fund well over 500mm and potentially 750mm — growing exponentially year over year. STIFF DRINK TIME. Since April 1st we have funded 5mm total through only 2 banks. Let’s dive in as to why.

SBA banks—they have lending limits to 5mm. Congress has authorized them to go to 10mm in the CARES Act but they have ignored it. This will become important later. They currently have guarantees from the govt at 80%—pretty good right? DOESNT MATTER THEY STILL WON’T LEND.

In fact, they are pushing the government to guarantee 90% of the loans (and likely on their way to 100%—see my prior posts on the de facto nationalization of the banking system). In short SBA has SHUT OFF BORROWERS waiting for more from Uncle Sam.

Current excuses ARE PLAYING BOTH SIDES (and this applies to all banking segments). A chain with increased sales since pandemic—no loan. “We want to wait to see if sales increases are sustainable.” Doesn’t matter that sales are up. They may not be “sustainable.”

On the other side for businesses with sales down—“well we just aren’t comfortable sales will rebound and we have concerns over COVID.” So, sales up = no loan. Sales down or flat = no loan. Operator size IRRELEVANT. Are some banks lending? Yes. This is 75–80% of SBA banks.

They are also being EXTREMELY selective on industries they will do. If you are an industry with “large public gatherings” you better pray to Santa Claus for money.

 
So, businesses with solid revenue still can’t get capital even when the government will guarantee 80% of the risk. Economic recovery will be very hard if this persists. All those loans not being made represent business activity that won’t happen, buildings not constructed, jobs not created.

It doesn’t mean the situation is hopeless. But it probably means we will be stumbling through this morass even longer.

Crowding Out

While others reach for credit, one borrower is having no trouble at all.

People are clamoring to lend even more money to the US Treasury, which is why yields are so low. Adjusted for inflation, they are paying to lend money to the government. Enormous amounts of it, too.

In the April-June quarter, Treasury borrowed $2.753 trillion in marketable debt. This week officials estimated they will issue another $947 billion in Q3 and $1.2 trillion in Q4. Q1 was $477 billion. So, for this calendar year, Treasury will have borrowed almost $5.4 trillion. Or maybe I should say “at least” since there is a very good chance these estimates will prove low.

Everyone (including me) expects Congress to pass another “stimulus” package. My best guess is it will be between $1.5 to $2 trillion. The bulk of that will be spent in 2020.

That means US federal debt will be $29 trillion and perhaps $30 trillion as we ring in the new year, or shortly thereafter. Not to mention $3 trillion in state and local debt.

It gets worse. From my friend Mark Grant (quoting Bloomberg):

Money managers just can’t get enough corporate bonds as the Federal Reserve supports the securities, and that demand is igniting the markets for issuing and trading company debt.

When Activision Blizzard, Inc. sold $1.25 billion of notes on Wednesday, the video game maker got orders for almost 10 times as many bonds. When Alphabet Inc., Google’s parent, sold $10 billion of debt securities on Monday, it garnered nearly four times as many orders. Last year that ratio averaged closer to three times. Junk bond issuance this week is at its fastest clip since mid-June.

Just last week, many dealers thought that companies were going to cut back on selling high-grade bonds, after most corporations had raised the money they needed to tide them over for the rest of the year. They expected as little as $50 billion of issuance in August, after volumes in July were down about a third from the year before.

Now the forecasts for August are increasing to as much as $75 billion, on the theory that companies might borrow more to lock in ultra-cheap borrowing costs. Yields in the $6.8 trillion high-grade bond market averaged just 1.83% on Wednesday, according to Bloomberg Barclays index data.

 
The Federal Reserve has basically said we are going to backstop high-grade corporate debt while doing little for small business. At least that is how lenders perceive the Fed’s action.

That’s the problem. Small businesses are the US economy’s engine and we’re starving them for fuel. People like me who worry about government debt often talk of a “crowding out” effect in which high governmental credit demand sucks limited capital away from smaller private-sector loans. Is that what’s happening now? Maybe. In theory, lenders seek the best risk-adjusted returns. They will risk loaning to unstable borrowers if they can set rates high enough. The high-yield bond market is one such segment.

So what counts is not so much the level of rates, but the spread between what a lender can make in Treasury paper vs. lending to businesses and individuals. It must be enough to match lenders who are willing to take more risk with borrowers who can pay higher rates. But other things count, too. Loan covenants, collateral, assorted other arcane details.

When Treasury yields are below zero in real terms, it shouldn’t be hard for a lender to sharply increase their income by making loans to reasonably stable borrowers at 5%, or to riskier ones at 10%. Yet it appears they aren’t eager to do that. Why?

I suspect it is because this is no ordinary recession. Its outcome doesn’t depend on normal economic forces or cycles we have seen unfold before. The economic weakness comes from a virus we can’t presently control whose presence stifles economic activity. The recession can’t end until something changes. There are three possibilities.

  • A working vaccine, deployed on a large scale worldwide,

  • Effective treatments that sharply reduce hospitalization and fatality rates, or

  • A large part of the population having been infected and survived with immunity.

When will any of those happen? We all hope it’s soon but we can’t know. This uncertainty renders normal credit analysis impossible. The restaurant industry will take years to recover. Ditto for travel and hospitality. If you’re a loan officer, lending to a restaurant or hotel right now is a pure gamble. Banks aren’t (and shouldn’t be) gamblers.

But this means the businesses which are the actual engine of growth for the economy can’t get credit. Scarce credit means scarce capital investment, and therefore little growth, if any.

Remember when we complained about GDP growing “only” 1% a year? Or, as some called it, secular stagnation? We may long for those days. They were better than we knew at the time.

The Absurd, Totally Misleading Unemployment Report

I cannot end this letter without commenting on the sheer insanity that passes for the headline unemployment report this morning. Here’s the lead.

In July, the unemployment rate declined by 0.9 percentage point to 10.2 percent, and the number of unemployed persons fell by 1.4 million to 16.3 million.

 
This number will be breathlessly reported in all the media but let’s look at reality on the ground.

First, Mike Shedlock offers this chart from yesterday’s continued unemployment claims.


Source: MishTalk

 
It certainly shows improvement over last week but this doesn’t reflect those on federal unemployment programs (again, I assume they will continue in some way).

If you add those in, you get 31.3 million workers receiving some kind of unemployment benefit.
 


Source: MishTalk

 
That is roughly double the number of unemployed that BLS reports.

The US workforce is about 160 million people so 16 million unemployed gives you the 10% unemployment number. If 31.3 million are unemployed (assuming those receiving benefits are actually unemployed, a reasonable assumption) then the unemployment rate is 19.6%.

Then add an unquantifiable number of those who don’t qualify for unemployment insurance of any kind, as in those who worked “off the books” for cash or otherwise fell through the cracks. It’s a significant number. This brings you to an unemployment rate easily 20% or more.

The BLS isn’t hiding this unemployment. They have systems developed over decades to track unemployment, and the current crisis/recession doesn’t fit neatly into that system. They do, however, track several items called “Alternative Measures of Labor Underutilization.” One of those numbers is the U-6 category, which shows 16.5% unemployment.


Source: Bureau of Labor Statistics (Click to enlarge)

 
Let me leave you with a final and somewhat depressing thought. Private investment fell roughly equal to federal spending last quarter. As much as it pains me to say, even acknowledging some of the stimulus money was wasted, without it the US and therefore the world would be in a deep depression.

The numbers above show we are nowhere close to “recovery.” Whatever stimulus package comes out of DC will be smaller and hopefully better targeted. But it will be absolutely necessary to keep the economy from truly collapsing.

(Just writing that forces a deep and audible sigh from me. Never once in my life did I think I would write those words. And that they would be true.)

To talk about a V-shaped or any other shaped recovery based on past history is sheer absurdity. The future recovery, and there will be one, will be unlike anything we have ever experienced, including even our (great?) grandparents (and for some of us our parents) in the Great Depression. This is a completely different economic animal.

Perhaps by understanding it, we can figure out how to get out of it for everyone’s sake, as well as determine our own individual paths forward. It will be the Stumble-Through Economy indeed.

Puerto Rico, Montana, Missing Maine, and Changing Life Habits

 
Week after next I will meet Shane in Missoula, Montana. I will be flying from Puerto Rico and Shane will be coming from Oregon after attending a spiritual retreat. I will be “batching” it this next week. We will then spend five delightful days with old friend Darrell Cain and some of his family at his home on Flathead Lake. The closest thing I will have to a vacation, as opposed to my permanent staycation, this year.

For the last 14 years, the first Friday of August found me at Leen’s Lodge in Grand Lake Stream, Maine. I find that I am truly emotionally missing it. Sadly, it was a major economic stimulus for that area and is now just another financial dent in what are truly small, mostly family businesses.

I have noted before how I miss my gym. It is once again closed, and in the two weeks it was open I noticed a significant drop off in attendance. It became quite easy to social distance. Then I read this note this morning from Neil Howe:

As gym owners reopen their doors, their worst fears are coming true: People aren’t coming back. Recent polls show that Americans are in no hurry to return to fitness centers. Morning Consult tracks weekly comfort levels for different activities during the pandemic. On the week of July 13, only 20% of Americans felt comfortable going to the gym. One week later, that share dropped to 18%. A different poll from TD Ameritrade found that 59% of Americans don’t plan to renew their gym memberships even once the pandemic is over.

 
This will play out in multiple service industries. On the flip side, I can’t get simple weights and other home workout equipment anywhere. All sold out here. Amazon won’t deliver. The barbell business must be booming. Big equipment workout iron? Not so much. I expect a lot of used gym equipment will go on the market in a few months as one gym after another goes bankrupt. Ditto restaurant kitchen equipment, hotels, planes, etc.

I hate being a Gloomy Gus, because I actually see fabulous opportunities all around me. When the world gets repriced, opportunities appear even as some doors close. Our job is to find the open doors. And with that, you have a great week!

Your home alone for the week analyst,


 
John Mauldin
Co-Founder, Mauldin Economics