MACROECONOMY

BOMBARDIER
BUSINESS CYCLES AND AIRCRAFT DEMAND

PROFESSOR NICOLAS VINCENT

Solenne Baillet Lauren Markofsky

Ravish Sharma Jay Modi
Joseph Abramson

June 2017

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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?
Our regression is:
Growth rate of real private fixed investment in aircraft = -8,9997 + 5,066 Growth rate of real
GDP

Data used: Real Gross Domestic Product, Percent Change from Preceding Period, Annual,
Not Seasonally Adjusted
The aeronautics sector is procyclical as the slope of the linear regression is positive.
p= 0,0024 so p<0,05 This result is statistically significant even if our R-square is low.

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.?
Growth rate of investment in aircraft
Real GDP growth of 2% 1,13 +/-7,51
Real GDP growth of 3% 6,20 +/- 6,67
A rise of 1 percentage point in real GDP growth would impact the growth rate of investment in
aircraft in the U.S by 5,07 percentage points.

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?

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 Regression 1960-1985:
Growth rate of real private fixed investment in aircraft = -13,747 + 5,955 Growth rate of real
GDP
p= 0,018
R-square = 0,211
Regression 1985-2015:
Growth rate of real private fixed investment in aircraft = -4,315 + 3,704 Growth rate of real
GDP
p= 0,128
R-square = 0,078

Growth in real GDP and aircraft investment are most correlated in sample period 1960-1985 as
R-square is higher (0,211 vs 0,078) and p is statistically significant (p<0,05).
The impact of real GDP growth on growth in aircraft investment is the largest in sample period
1960-1985 as we have an higher slope (5,955 vs 3,704). In fact, the impact of a rise of 1
percentage point of real GDP growth in sample period 1960-1985 increase growth in aircraft
investment by an average of 5,96 percentage point against 3,70 in sample period 1985-2015.

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?
Growth rate of Real Gross Private Domestic Investment = -2,35 + 2,30 Growth rate of real GDP

Aircraft investment is more cyclical as slope (5,07) is higher than Real Gross Private Domestic
Investment slope (2,30), even if the fit is not as good R-square of 0,16 vs 0,62.

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p= 6,016E-13 so p<0,05 The coefficient on real GDP growth 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.
Methodology: We used our linear regression equation and used our regression tool to predict
the next years growth rate of real private fixed investment in aircraft as well as the 95%
Confidence interval.
Growth rate of real private fixed investment in aircraft = -8,9997 + 5,066 Growth rate of real
GDP
Growth rate of real GDP Growth rate of real private fixed investment in aircraft
2016 1,6 -0,89 +/- 8,17
2017 2,3 2,65 +/- 7,11
2018 2,5 3,67 +/- 6,92
As we only have data up until 2015 for real private fixed investment in aircraft we provide you
with an estimate value for the next 3 years.

f. Forecasting the macroeconomy 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 (d). Indicate the growth rate of aircraft investment under each of these situations for
this year and the next.

% change in growth of real GDP -1 -2 -3

% change aircraft 2016 -5,96+/-10,35 -11,03+/-12,97 -16,09+/-15,79
% change aircraft 2017 -2,41+/-8,76 -7,48+/-11,11 -12,55+/-13,8
% change aircraft 2018 -1,40 +/- 8,36 -6,47 +/- 10,6 -11,53 +/- 13,24
As we only have data up until 2015 for real private fixed investment in aircraft we provide you
with an estimate value for the next 3 years.

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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 Bombardiers 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 thats 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 Canadian debt situation is more worrisome than in most developed countries including the
U.S. and U.K. The U.S. and U.K. went through a multi-year deleveraging processes including
debt/income reduction and house price deflation, while Canada did not. As a result, Canadian
household debt/income levels are extremely high compared to either history or other developed
markets, including the U.K. and U.S. (Figure 1 and 2) In fact, Canadian household debt/income
levels are currently above where the U.S. peaked in 2006, just before a multi-year deleveraging
process ensued.
Likewise, Canadian home prices are quite overvalued relative to their long-term trend,
Canadian incomes or rent. Canadian housing is also extremely expensive on any of these
metrics relative to most developed markets including the U.S. (Figure 3, 4 and 5). Ominously,
Canadian home price valuations are currently above levels witnessed in the U.S. peaked in
2006, just before the housing bubble burst.
In sum, home prices in Canada appear to be in a bubble. But, even if they are not, valuations
are quite expensive and are not supported by incomes. Consequently, though the timing is
unclear, the bursting of this bubble will probably not be gentle.
In Canada, the household debts is higher and real house prices are too. This means that
household would have less money to spend on their airtravel if they want to save and invest for
their future house. Young household that usually travel a lot will save more money and reduce
their leisure spending in order to be able to buy an house.

ii. the impact a sharp correction in house prices would have on the aggregate Canadian
economy, household income and airline demand;
A sharp correction in home prices has no direct effect on income, but can have a meaningful
impact on the broader economy via a negative wealth effect. Economic weakness in turn,

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would have a substantial negative impact on airline demand given that the airline industry is
highly cyclical.
There are three major channels through which the bursting of the housing bubble could
influence the Canadian economy:
Residential investment. The direct impact of residential investment on the Canadian
economy is relatively small given that it represents less than 10% of GDP. Even if the
influence of housing related employment such as real estate agents, furniture and
banking is included, a housing downturn is probably not large enough to directly cause
a full-blown recession.
Credit/banking channel. We agree with the Bank of Canada that a severe housing
correction is unlikely to cause a U.S. style banking crisis. Canadian mortgage lending
standards are quite conservative, Canadian banks have relatively high levels of capital
and CMHC mortgage insurance covers most high-risk mortgages (>80% LTV). In sum,
declining home prices are more of a government problem than a banking problem. That
said, Ricardian equivalence means that there is some potential for Canadians to reduce
spending if the bubble bursts in the expectation that taxes will go up in the future.
Negative wealth effect. The major channel through which the bursting of a housing
bubble can impact the Canadian economy is through the negative effect that a loss of
wealth will have on consumption. Like in the U.S. last decade, more and more
Canadians are remortgaging their homes to free up cash for consumption. More
importantly, rising home prices have allowed Canadians to save less than they should.
Housing is the major asset for most Canadians and over two-thirds of Canadians own
their home. If home prices decline substantially the loss in wealth will cause Canadians
to increase their savings especially if they are nearing retirement as many baby boomers
are.
For example, a 15% home price decline would result a loss of $56,000, which represents more
than a full years disposable income.1 A loss of wealth of this amount would almost certainly
lead to a meaningful increase in savings, therefore a substantial decline in consumption, which
represents the bulk of the Canadian economy. Partially offsetting the negative wealth effect
would be declining interest rates and a falling currency.

1
The price of the average Canadian house is $375,000 and the average Canadian household earns about $80,000
per year.

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Airline demand is highly cyclical, with an income elasticity below -1, so weakness in the
broader economy would have an outsized negative impact on domestic airline demand,
especially among high margin business customers. There would be some offset via an increase
in tourism into Canada because of a cheapening currency, however this would largely be in the
low margin non-business segment and more than offset by declining outbound Canadian
tourism.

iii. the challenges faced by the Bank of Canada in trying to deal with the scenario you
described in (ii)?
It is always difficult for a central bank to manage asset bubbles, such as the one in Canadian
housing. How is a central bank supposed to know what the right price is? And if it does, how
can it manage prices to this level with blunt instruments like interest rates without creating
substantial problems in other parts of the economy. Of course, the Bank of Canada (BoC) could
unwind certain macroprudential housing measures, but this is largely out of their control and
relatively limited. Moreover, there is currently only a small amount of room for rate cuts since
both interest rates and bond yields are quite low so the potential for expansionary policy through
the interest rate channel is relatively limited.
More importantly, Canada is a very externally driven economy given that it is fairly commodity
intensive and export driven. As a result, the BoC must take a monetary conditions approach,
which takes both interest rates and the currency into account. The major channel to stimulate
the economy is via the impact currency depreciation on net exports and net foreign investment
to offset domestic weakness since rates are low. However, there are long and uncertain lags
involved and this policy would risk creating long-term imbalances in the external part of the
economy.

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 (your answer should not exceed 400 words).
Advanced economy GDP growth is supposed to accelerate to a still below-trend 2% growth in
2017, according to the IMF. The major upside to this weak forecast is substantial fiscal stimulus,
while the major downside comes from rising protectionism.

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More specifically, the IMF expects the U.S. to be the major driver of accelerating developed
market growth. The most likely candidate for upside lies in substantial fiscal stimulus, largely
through corporate tax cuts, though the size of the fiscal multiplier is unclear. In a parallel
fashion, the greatest potential downside is if Trump does not have the political capital to
implement the fiscal stimulus baked into these forecasts.
Other sources of U.S. positive surprises lie in the potential for an equity or housing boom to
bolster spending via the wealth effect. Rising protectionism is a potential downside given that
trade is a non-zero-sum game. More importantly, the Fed could make a policy mistake by
getting overly restrictive. Slow productivity and population growth suggest that trend GDP
growth and the neutral rate are only about
1.75%. It will also be tricky for the Fed to unwind its balance sheet as this has never been done
before. Lastly, an external supply shock such as a war in the Middle East leading to a doubling
in oil prices, could weaken growth, as it has in the past.
There is greater potential for euro area upside since expectations are lower with growth
expected to remain flat in 2017. The largest source of upside lies in the potential for past euro
weakness coupled with accelerating external growth to result in an export and FDI boom. The
biggest source of near-term downside comes from a rrade war given that the euro area is quite
externally driven and there is increasing populist and anti-globalization sentiment in their major
trading partners, the U.S. and U.K.
Japan matters little to the world since it has been in a deflationary abyss for so long. That said,
growth is expected to only accelerate slightly in 2017 and decline massively to 0.6% in 2018.
As such, there is potential for upside in Japan. The major source of positive surprises is the fact
that the economy is done deleveraging after completing a 25+ year unwinding. Real estate
prices are rising and debt/GDP is now increasing. The major source of downside remains
unwanted currency strength, which is generating a substantial deflationary impulse.

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Charts and Tables:

Figure 1:

Figure 2:

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Figure 3:

Figure 4:

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Figure 5:

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