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Team Assignment Paper: Group 20

Understanding the Business Environment of the Firm

Business Cycles and Aircraft Demand

56-040-13A.E2017.J53

Submitted to

Professor Nicolas Vincent

26 June 2017

Kashan Awais (11238413)


Malini Jain (11237895)
Teerathut Lerstsakwimand (11234784)
Joseph Monroe (11237648)
a. Using Excel or any other software, run a linear regression of the yearly growth rate of
real private fixed investment in aircraft on a constant and the growth rate of real GDP, starting
in 1960, and report the results. Based on the findings from your regression, would you conclude
that the aeronautics sector is procyclical, acyclical or countercyclical? Is this result significant
statistically?

Coefficients Standard Error t Stat P-value Lower 95% Upper 95%


Intercept 72.07258645 8.659305302 8.323137 2.98E-11 54.7117246 89.43345
GDP 0.007573891 0.001016497 7.450972 7.63E-10 0.005535937 0.009612

GDP Line Fit Plot


300.000

250.000
Quantity index

200.000

150.000
Quantity index
100.000 Predicted Quantity index

50.000

0.000
0.0 5000.0 10000.0 15000.0 20000.0
GDP

Regression equation:
Y (investment) = 72.0725 + 0.0075(GDP)
The given regression analysis indicates that there is a prominently visible correlation between the
investment in aircraft and the level of GDP; which, in turn, means that the aeronautics sector is
procyclical and any investment made in this sector bears a direct relationship with any changes in the
GDP. Since the p-value obtained in the analysis is very small it indicates that the relation between the two
variables is highly significant.

b. Based on your regression results, can you give us a sense of how much a rise of 1
percentage point (e.g. from 2% to 3%) in real GDP growth would be expected to impact, on
average, the growth rate of investment in aircraft in the U.S.?

As per the given regression equation, we determine that on the any unit increase in GDP will
result in an increase in the investment by a factor of 0.0075 approximately. In terms of
percentage however, the effect is not uniform and the percentage change in the investment varies
at different levels of GDP. At lower levels of GDP the percentage increase in investment is
negligible. However as the level of GDP increases the percentage of investment keeps
increasing. The tables given below have been derived from the same regression analysis, and
illustrate the effect of change in the independent variable in terms of percentages.

GDP %increase in GDP Investment %increase in investment


100 -- 72.829976 --
101 1% 72.837549 0.0104%
102.01 1% 72.845199 0.0105%
103.0301 1% 72.852925 0.0106%

GDP %increase in GDP Investment %increase in investment


5000 -- 109.94204 --
5050 1% 110.32074 0.3444%
5100.5 1% 110.70322 0.3467%
5151.505 1% 111.08952 0.3490%

GDP %increase in GDP Investment %increase in investment


15000 -- 185.68095 --
15150 1% 186.81704 0.6118%
15301.5 1% 187.96448 0.6142%
15454.52 1% 189.1234 0.6166%

c. Run the regressions for two sample periods: 1960-1985 and 1985 to now. For which
sample period are growth in real GDP and aircraft investment most correlated (best fit of the
regression)? For which period is the impact of real GDP growth on growth in aircraft
investment the largest?

1960-1985 (correl: 0.5148)


Coefficients Standard Error t Stat P-value Lower 95% Upper 95%
Intercept 54.03251771 10.62001025 5.087802784 3.32817E-05 32.11389383 75.95114158
GDP 0.014809706 0.005034121 2.941865047 0.007121935 0.00441979 0.025199622

GDP Line Fit Plot 1960-1985


160.000
140.000
120.000
Quantity index

100.000
80.000 Quantity index
60.000
40.000 Predicted Quantity
index
20.000
0.000
0.0 1000.02000.03000.04000.05000.0
GDP
1985-2015 (correl: 0.4205)
Coefficients Standard Error t Stat P-value Lower 95% Upper 95%
Intercept 102.4311435 22.965147 4.460286865 0.000113307 55.46214412 149.4001429
GDP 0.005066735 0.002030089 2.495819461 0.01850315 0.000914737 0.009218733

GDP Line Fit Plot 1985-2015


300.000
250.000
Quantity index

200.000
150.000
Quantity index
100.000
Predicted Quantity index
50.000
0.000
0.0 5000.0 10000.0 15000.0 20000.0
GDP

The analysis indicates that the period between 1960 and 1985 demonstrates a higher correlation
(0.5148) between the two variables as compared to the one between 1985 and 2015 which has a
lower correlation (0.4205). Moreover we have higher p-values for the latter period as compared
to the former, indicating that in this case the relation between the two variables is statistically
less significant.

d. Now do the same exercise but using total real private non-residential fixed investment
(use the series that is available starting from 1929) instead of aircraft investment. Would you say
that aircraft investment is more or less cyclical than non-residential investment in general? Is
the coefficient on real GDP growth significant statistically?

Starting from 1960 the data for corresponding years of non-residential investment was extracted
from the source provided and a regression analysis was run, yielding the following results.

Coefficients Standard Error t Stat P-value Lower 95% Upper 95%


Intercept 12.90159697 1.213511898 10.63162 7.48147E-15 10.4686521 15.33454184
GDP 0.006755898 0.000142452 47.42594 1.0722E-45 0.0064703 0.007041496
GDP Line Fit Plot
160.000
investment Q index 140.000
120.000
100.000
80.000
investment Q index
60.000
40.000 Predicted investment Q index

20.000
0.000
0.0 5000.0 10000.0 15000.0 20000.0
GDP

As it is clearly evident from the graph above, as compared to the investment in aircrafts the level
of fixed private non-residential investment bears a stronger correlation with the GDP. The value
of this correlation is 0.988 which means that this relationship is more procyclical and a very low
p-value of GDP’s coefficient indicates that its relationship with the dependent variable is
statistically significant.

e. Based on your regression results, what would be the predicted growth rate of aircraft
investment for this year and the next? Please make sure to indicate your methodology.

Referring back to the regression equation that we derived earlier in our analysis of aircraft investment and
GDP from 1960 to 2015:

Y (aircraft investment) = 72.0725 + 0.0075 x GDP


When we plug in the values of GDP of 2016, 2017 and 2018 based on the IMF estimates and projections
we find the growth rate in aircraft investment as follows:

GDP Aircraft Investment


GDP Growth rate investment growth rate
2016 18325.19 1.60% 209.511 1.044%
2017 18746.66 2.30% 212.672 1.509%
2018 19215.33 2.50% 216.187 1.653%
f. Forecasting the macro economy is notoriously difficult given the number of moving
parts and the shocks hitting continuously the global economy. For this reason, we want to get an
idea of what a “worst-case scenario” would imply for the aircraft sector. In other words, we
would like you to conduct a simple sensitivity analysis. To do this, consider scenarios where the
growth rate of output is 1, 2 and 3 percentage points lower than the scenario you considered in
part (e). Indicate the growth rate of aircraft investment under each of these situations for this
year and the next
The decrease in growth rates by the given percentages not only translates into a slow growth but
in many scenarios it essentially means a negative growth or a crunch in GDP figure as compared
to that of the preceding year. Following tables describe the impact of these scenarios on the
aircraft investment.
Scenario A (1% slower growth)
GDP
Growth Aircraft Investment growth
GDP rate investment rate
2015 18036.6 207.347
2016 18144.82 0.60% 208.158647 0.391%
2017 18380.7 1.30% 209.9277669 0.850%
2018 18656.41 1.50% 211.9955959 0.985%

Scenario B (2% slower growth)


GDP
Growth Aircraft Investment growth
GDP rate investment rate
2015 18036.6 207.347
2016 17964.45 -0.40% 206.805902 -0.261%
2017 18018.35 0.30% 207.2101022 0.195%
2018 18108.44 0.50% 207.8857902 0.326%

Scenario C (3% slower growth)


GDP
Growth Aircraft Investment growth
GDP rate investment rate
2015 18036.6 207.347
2016 17784.09 -1.40% 205.453157 -0.913%
2017 17659.6 -0.70% 204.5194924 -0.454%
2018 17571.3 -0.50% 203.8572574 -0.324%

g. Two topics that have garnered a lot of interest lately in Canada are the high household
debt levels and the recent boom in house prices. Some executive committee members are
concerned that these two elements represent some significant downside risk for the demand
faced by Canadian airlines, and as a result the outlook for Bombardier’s sales in the country.
This is particularly concerning given the fact that Air Canada is expected to be a large customer
of the CSeries (or at least that’s the hope!). Using external sources as well as the AD-AS model,
can you enlighten us briefly on:

i. the reasons why the Canadian situation is a particular source of concern relative
to, say, the U.S. or U.K.;
The soaring housing prices have an indirect impact on the air travel because higher mortgages
result in higher household debts and shift the spending away from other leisure activities like
shopping and vacations. House prices have increased at a higher rate in Canada (about 5% to 7%
per year) from 2008 to 2015 and current figure indicates a Y/Y increase of a staggering 13.86%,
whereas in UK and US this increase has not been as high. The graphs given below illustrate this
difference in house price index among Canada, USA and UK.

House price index USA


House price index UK

House price index Canada

Source: https://housepriceindex.ca/#chart_change=c11
This comparison indicates that unlike their American and British counterparts, Canadian
households are more likely to incur a higher financial burden to heavier mortgages and may be
less likely to spend much on air travel, pushing the demand curve to the left which could have
implications for the Canadian airlines.

ii. …the impact a sharp correction in house prices would have on the aggregate
Canadian economy, household income and airline demand
A sudden drop in house prices by 10% or more can have serious fallout on the Canadian
economy. It can trigger a crash similar to the one Toronto experienced in 1989. It goes
without saying, at the same time, that the great recession in not a remnant from the past
and we understand that the effects of a price correction can be overwhelming. The
property that people own will all of a sudden will be devalued for which they are paying
hefty mortgage payments. Reselling the houses and moving to other places for work can
become quite less feasible and this could lead to increased unemployment. While the
available income to the households is already reduced due the heavy debt, increase in
unemployment can lead to a decrease in demand for the Canadian airlines, all these
factors translating into a direct impact on the overall GDP, the value of currency and the
aggregate economy of Canada.

iii. …the challenges faced by the Bank of Canada in trying to deal with the scenario
you described in (ii)?

Although Bank of Canada is confident that the spike in house prices and the housing
bubble in Toronto and Vancouver cannot turn into something that happened in the U.S.
and the reason behind this confidence is the financials checks and systems the Bank has
in place here. For example here in Canada the mortgage rules have been made more
stringent by incorporation of certain conditions such as mortgage insurance, stress test,
low ratio insurance and tax rules. However Bank of Canada still faces the challenge
whether these systems will actually be effective in achieving their goals as one notable
factor in increasing house prices is foreign buyers. While all these strict rules will apply
to the Canadian consumers and make it more difficult for them to buy new houses, the
foreign buyers might not be as deterred from their investments and a continued trend
might keep the prices going up in future as well, which will keep the Canadian buyers’
debt ratio higher. On the other hand, if radical measures are taken such as a foreign buyer
tax (just like BC imposed) or a ‘flipping tax’, this could result in a price correction which
would have a negative impact on the economy as described previously.
h. More generally, what do you see as the main factors that could disrupt the current
consensus regarding growth prospects in the short run? In your answer, focus on the mature
aircraft markets (i.e. the main advanced economies of U.S., Europe, Japan, etc.) and make sure
to be brief, clear and concise, limiting yourself to the two or three main upside or downside risks
to the macroeconomic outlook in your opinion

Although we do not see any astounding projections of growth, developed economies, on the
whole, show reasonable prospects for steady growth. For example UN statistics show that
Europe is expected to grow between 1.7% to 3.3% in 2017-2018, depending on whether we are
talking about the developed economies like EU-15 or the ones like EU-13 that are more of
transition economies. Similarly US has a projected growth of 1.9% and 2% for 2017 and 2018
respectively. Japan, on the other hand, does not seem to be particularly on the rise in terms of
growth and is expected to grow 0.9% in coming two years.

Although an overall growth in these economies should mean a steady increase in the aggregate
demand for air travel, and in turn for the aerospace manufacturing sector, to cater for which
companies like Bombardier are eager to offer a supply; but there are multiple factors that can
disrupt the demand expectations for aircrafts markets in particular and overall macro economy in
general.

One main downside risk could result from uncertainty in countries’ policies and protectionist
approach they might adopt. US stance on NAFTA, litigation against aircraft manufacturers for
charges of unfair government subsidies, etc. could be the examples of such risks which could
change the outlook of how the industries compete or how the countries set the rules for playing
field.

Another risk that can severely disrupt the economy and the air travel is the risk of terrorist
activities. While growing tension between two countries and a possibility of a war is something
that can be predicted and its potential impact on the economies can be forecasted but this is not
the case with terrorist activities which can inflict a massive blow on the economy in the short
run.

Other phenomena such as a housing boom that led to the great recession, can potentially pose an
upside risk to the macro economy of a country or a region. As it was referred to an the answer to
a previous question, the housing bubble in Vancouver and Toronto can have a trickle down effect
in other parts of the country and can lead to an overall high debt ratio in the country. This, in
turn, can lead to reduced available income, less spending, an overall shift of demand curve to the
left and reduced growth in the economy as a whole.