City Insider - FT journalist David Stevenson on the travel industry

Investors are fickle and emotional creatures. in for the travel sector, with many investors actively short selling the leaders such as Thomas Cook and even Tui Travel.
Now the City has rekindled its faith in the travel sector and the turnaround has been nothing short of miraculous – more than a few of travel’s leading lights have seen a doubling or even trebling of their value over a relatively If we look at how that truculent behaviour expresses itself in share prices, we discover that institutional investors tend to over react on both the way up and the way down.

Just a short while ago City investors had it short period.

My own suspicion is that this recently acquired confidence in the sector is now in danger of turning into irrational exuberance with very predictable and depressing medium term consequences.

This growing sense of foreboding is not in any way a comment on the global outlook for equities – which is probably optimistic, in a rather pedestrian way – but a simple reality check on the headwinds facing the big travel companies as we sail into what looks like a more confident start to 2013.

The general rule is that stockmarket investors like to get ahead of the macroeconomic curve, which means that we should typically expect investors to become hugely optimistic about six months ahead of tangible signs of an upturn.

One half of that statement (the upturn in confidence part) has certainly come true, with the average share price of a travel company increasing by more than 50% over the last six months.

And there is indeed an upturn on the cards at the global economic level, with two key positive drivers at work – the surprisingly strong rebound in the US housing market, which feeds through into an upsurge in consumer confidence, plus the expected rebound in China, as its local consumers race out to the shops to spend more money.

So far, so good then for travel sector investors?

But investing isn’t only about ‘the big picture’ ie how the shares in a company react to the big macro-economic forces. Sector specific factors also come into play, especially as the stockmarket overall starts to regain its confidence.

A more hopeful market tends to start discriminating between those areas of the economy that perform better than expected, whilst punishing those with poor numbers.

And herein is the challenge for the travel sector in 2013 and beyond – share prices have already priced in a big jump in top line and profits growth, but sector dynamics are highly likely to disappoint.
Why my caution for the short term prospects travel sector?

Over the last few weeks I’ve been talking in detail to a wide range of economists and traders about the travel sector, and a simple message keeps coming back – the travel sector will have to contend with very negative and inter related headwinds in the remainder of the year.

The first and probably most important factor centres around the declining value of the pound.

It’s absolutely no secret that FX traders take a dim view of the prospects for sterling but I don’t think that many in the travel sector realise just how grim that view is.

Last week I talked to a bunch of options traders who settle medium-term hedging strategies for large multinationals, and although every one of the traders was at first non-committal about one year price targets for sterling, not one of these specialists, on closer questioning, ‘personally’ felt that sterling has a cat in hells chance of staying above 1.05 to the Euro and 1.40 to the dollar.

In fact at least three of the five traders I talked to were busy writing hedging positions well below those levels for names we’d all recognise.

In simple terms sterling is toast and no amount of ‘crowing’ about troubles in the Eurozone with Italy will delay the inevitable.

Yes France is clearly the weak man of the Eurozone but to actively short the Euro means taking a bet against the powerhouse that is Germany – which has surprised all of us (myself included) by being a great deal more resilient in the last few months than we’d expected. Sterling on the other hand is easy to pick off and our fundamentals look absolutely dreadful.

This weak backdrop for sterling – and a growing consensus that the UK is the weak man of the AngloSaxon world – is terrible news for the travel sector.

It makes those foreign holidays more expensive. That doesn’t necessarily mean that customers won’t travel, but it does mean that they’ll place ever more focus on all inclusive packages to keep costs to the absolute minimum.

Again, that needn’t be bad news for travel operators like Tui Travel but I wonder just how far they can keep absorbing these FX movements without killing the profit margin.

Weak sterling will also impact hugely the next key factor, which is that consumer demand will likely stay very weak at best and possibly deflate in the second half of 2013.

Many economist reckon that we’re moving into a ghastly groundhog day like pattern where the first half of a year brings all the good news (consumers feel a little more confident) but that by the second half of the year that confidence has ebbed away as the realities of a low growth world set in.

In simple terms the H1 rebound is inevitably followed by the H2 disappointment. My sense is that this could indicate a much tougher second half to 2013 especially as the government spending cuts impact at home.

Lower credit ratings for our government’s debt issuance and general bearishness about sterling’s prospects will likely intensify the Chancellor’s determination to cut spending even more than he’s already announced to hit his own self-imposed targets.
The optimists hope that the UK housing market might start to copy its US counterpart and help to underpin the current small upturn in confidence, but I wouldn’t put any money on that outcome.

The reason why the Bank of England has started contemplating extreme measures like paying negative interest rates is because it knows that the UK housing market is stuck in the doldrums, with most new mortgaging originating from wealthier remortgagers who can pass most bank and building society credit checks.

Sterling’s likely steady decline will only worsen this grim domestic situation as it will push up costs for imported items and squeeze domestic, middle class earnings.

Cue the third factor, which is yet another negative for the sector – oil prices.

Without wanting to sound like a broken record, this column has been warning for ages that oil prices will remain at elevated levels for quite some time.

Talk of a collapse in oil prices below $80 a barrel is pure hogwash and recent market conditions merely reinforce this pessimist take on the energy markets.  What’s driving the price of oil? Put simply, changes in demand at the ‘margins’, both in demand and supply.

As employment growth declines dramatically, we see oil prices fall off a cliff – equally as US payrolls start to pick up, we see oil prices rise.

The relationship is, of course, hugely complex and can’t be summed up in a simple linear way (with some evidence to suggest that oil markets tend to overreact on the way up and down again) but all my indicators suggest that the US is witnessing sustained employment growth, with the US housing market now beginning to kick some growth in jobs back into the machine.

That – along with resurgent Chinese demand – could result in oil prices rising again from current levels, driven largely by increased demand, with likely extra supply only marginally higher.

Most energy traders I talk to are expecting a near term high of $130 a barrel, although the impact on UK consumers could much greater because of our declining sterling rate. To understand this double whammy, let’s imagine that oil prices peak at $130, implying a rise of just under 15% from current levels. Yet that increase becomes 22% for UK consumers if sterling hits $1.40 on the FX markets.

None of us need any lessons on what happens when UK consumers react to increasing fuel prices – this essential input cost will punish poorer and middle income households disproportionately hard.

The bottom line?
It’s indisputably great news that investors are beginning to appreciate the attractions of the UK travel sector again, and if I were one of those lucky companies with a robust business looking to float my shares on the UK stock market, I’d make sure that I made my move to a listing as soon as possible.

I’m also fairly positive overall about the pace of economic growth globally, which will surprise us to the upside as US consumers start spending again.

I’d even be fairly positive about the long term prospects for equities. But the UK economy is a mess and sooner or later investors will begin to start worrying again about prospects for discretionary consumer spending here in the UK and in the travel sector generally.

They’ll worry that top line sales growth is coming at the cost of bottom line profit margins, especially as sterling weakens. That could spell a nasty sell-off in shares in the sector later in the year.