VIDEO: A High-Level Look at Aerospace/Defense

Welcome to my video interview with Richard Aboulafia, managing director of the aerospace consulting firm, AeroDynamic Advisory.

Since 1988, Richard has tracked aircraft programs, markets, and companies as an analyst. He also manages consulting projects in the commercial and military aviation field. Defense News has listed Richard as among the “100 Most Influential People” in the defense industry.

Below is a condensed transcript of our conversation. The video contains charts and additional details.

The coronavirus pandemic has wreaked havoc on commercial airlines, an industry that’s a leading economic indicator. Now that the pandemic is waning, are commercial air carriers rebounding? How long will it take the major carriers to get back to pre-pandemic levels of revenue and profitability?

I remember when the pandemic broke out about two years ago and we were wondering what the shape of the commercial aviation recovery would look like.

The upward trajectory has remained consistent, and sometime in the second half of 2023, we’ll get back to where we were in 2019. But the problem is, we’ll have lost long-term ground.

Our latest estimate shows that in 2025, years after we’ve hopefully forgotten COVID, we’ll still be 11% impaired in the airline sector, relative to where we would have been, had none of this happened.

And then there’s the war in the Ukraine, which is delaying by a modest amount some of the recovery in international traffic, but thankfully, domestic markets are still on track.

After labor, fuel is the major cost for commercial air carriers. Crude oil prices, and accordingly the cost of jet fuel, have been soaring. How badly have higher energy costs hurt the airlines and when might they get some relief?

You can lose a lot of money trying to predict the future price of oil. The latest estimates from the U.S. Energy Information Administration is that the average price for West Texas Intermediate this year will turn out to be about $100 per barrel, which is bad, but not catastrophic. The peak was $147 per barrel back in July 2008.

Airlines will have to pass along these added fuel costs to consumers, in ticket prices. Right now, the commercial airlines haven’t done much of that, because they’re concerned about the fragile nature of the air travel recovery. But they won’t have much choice.

We’ll soon see higher ticket prices. Hopefully, that won’t put the kibosh on the recovery, but it’s an area of risk.

Due to Russia’s invasion of Ukraine, the U.S. and major Western countries are planning to significantly increase defense expenditures. Doesn’t that make the major defense contractors good investment bets now? Or has this boost in spending already been factored into their share prices?

Since Russia’s invasion of Ukraine in late February, there’s been a significant rise in the share prices of the major aerospace/defense contractors. But I think this share price appreciation has some traction ahead.

We’re just coming to terms with the new realities of the geo-strategic environment. It’s clear that there won’t be a sudden, happy end to the Russia-Ukraine conflict. We’ll remain in a confrontational situation into the foreseeable future.

Also, China is not breaking with Russia. We face the nightmare scenario of the Western democracies confronting two authoritarian peer adversaries, for years to come. This is a human tragedy of untold proportions, but it also means much higher defense spending, for a long time. A lot of money will be coming into the defense industry.

We’re facing recession warnings, but the aerospace/defense industry tends to be recession resistant, correct?

As the saying goes on Wall Street, defense is defensive. If you go back to, well, forever, and do a data chart that correlates defense spending with economic indicators such as recession years or debt levels, you’ll see zero correlation.

The only external factor correlated with defense spending is threat. That’s it, whether the threat is real or politically perceived. From the perspective of defense spending, that’s a guarantee of growth, especially moving forward, because we face several years of a serious military threat.

On the commercial side, for the first time in my experience, the industry has badly lagged the rest of the economy. It will be interesting to see to what extent the commercial recovery from the pandemic keeps going, even if there is a recession.

I’m betting that the commercial recovery will proceed, because the dynamics associated with the COVID-19 travel downturn were so profound, we’ll still see a recovery even if the economy begins to slacken.

Many investors would be surprised to learn that aerospace/defense stocks provide an effective hedge against inflation. Please elaborate.

That’s a key point. The majority of defense contracts are cost-plus. Whatever contractors pay for labor, materials, energy, what have you, it gets reimbursed with a guaranteed profit margin on top.

On the commercial side, hard assets, especially mobile ones, are actually a pretty good hedge against inflation, too. You wouldn’t think that, but they work just fine that way. So broadly speaking, aerospace/defense is one of your best hedges against inflation.

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John Persinos is the editorial director of Investing Daily.

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