Brexit negotiations and dollar strength likely to loom large over the EU airlines already grappling with overcapacity, according to Moody's. iStock

The operating profitability of European airlines is likely to decline in 2017 as a widening supply/demand gap would push yields lower, according to Moody's.

In a new report for its clients, the global ratings agency noted that the combined fleet of Ryanair, easyJet and Norwegian Air Shuttle, the three largest low-cost operators in Europe, will grow 12%, far outstripping anticipated demand growth in the continent of 4%.

Sven Reinke, vice president and senior credit officer at Moody's, said the development was likely have a negative impact on the industry.

"With recent terrorist attacks in Europe and a stronger dollar, growth in passenger demand for air travel is slowing at the same time low-cost airlines are significantly ramping up capacity."

Moody's noted that incumbent airlines, such as Lufthansa, British Airways, Air France and SAS are likely to lose some market share to low-cost airlines as they begin to offer lower fares on the same routes.

On short-haul routes, yields (measured in revenues per available seat kilometre) will likely drop further if Ryanair and easyJet lower their fares materially as they have indicated (15% for Ryanair, high single digits for EasyJet).

Overall, Moody's sees lower short-haul ticket prices across European airlines as inevitable if the two largest European short-haul airlines drop their prices. Furthermore, the agency opined that European carriers will increasingly feel the impact of the stronger dollar over the next couple of years "as a much larger portion of their cost base is denominated in dollars (i.e. with oil traded in dollars) compared to their revenues."

A double-whammy could follow if rising costs of dollar or dollar-linked holidays end up dampening demand from European tourists over the next 12 months. "At the same time, US tourists – who could offset lower European outbound bookings – might remain concerned about the threat of terrorism in Europe," Moody's added.

Brexit negotiations are also likely to loom large over the industry. Moody's said UK airlines such as BA and easyJet would not be the only ones affected if the UK exited the European Common Aviation Area (ECAA) without a new bilateral agreement with the EU.

"Euro area airlines with UK operations could also take a hit, particularly Ryanair, which generated 28% of its revenues in the UK in 2016," the agency concluded.