The Shifting Winds in the US Auto Sector

27 Jun 2017

  • The recent Federal Reserve Senior Loan Officers survey showed that while demand for US auto loans has weakened, banks are tightening lending standards for the borrowers who are seeking loans. As the Federal Reserve continues to hike interest rates, it will only become more expensive for consumers to finance vehicle purchases.
  • Auto sales have declined year to date despite used vehicle prices falling 7.6% since May 2016 and dealers increasing incentive spending by 11.9%.
  • If current trends continue, the US auto sector will act as a negative headwind to US GDP and US CPI growth.

In case you missed it, US retail sales in May were a paltry -0.3% month-over-month (MoM) with a sequential deceleration year-over-year (YoY) to 3.8%. In the past I’ve written about the US retail department store sector and the challenges it is facing and will face until a new equilibrium has been reached. And you wouldn’t be wrong to put the blame on this segment of the economy as the culprit holding down aggregate retail sales. But there is a new musty smell in the retail sector which will have far greater implications: US auto sales. On the Sector Rotation team, we focus on sequencing the business, economic, and earning cycles. The US auto sector is no different and has its own cyclical pattern that can largely be defined as <stable used car values -> stable trade cycles -> stable new car sales velocity-> positive contributions to GDP and Consumer Price Indexes (CPI) >.

The majority of new vehicle transactions involve a trade vehicle, and strong used vehicle values lead to a quicker trade cycle. Roughly one third of all new vehicle sales are from leases – with 2016 setting a new penetration record. The leasing market is driven by “residual value”, or the lender’s estimation of what a vehicle’s value will be upon taking it back at the end of its lease. Residual value is almost exclusively determined by current and forward estimates of used vehicle prices. Therefore, the wider the residual value, the higher the monthly lease payment. New and used car buyers are price sensitive to monthly payment amounts.

When current used car values start to fall, future residual value widens. As a result, new vehicle lease payments will increase and new vehicle sales will slow. To counter this widening, auto producers implement incentive programs to keep monthly payments manageable and current vehicle sales growing. Data as of May 2017 shows that dealer incentives have increased 11.9% from May 2016 and represented the 26 consecutive monthly incentive spending increase.

But this strategy only delays the inevitable as used car prices continue to fall under the weight of off-leasing vehicles. Last year, 2016, saw off-leasing of 2.8 million cars, and we expect this figure to grow to around 4.8 million by 2021. If incentive programs are unable to offset the declining used vehicle values, it is very likely we will see a decline in new vehicle lease sales. Our first chart of the week shows exactly this with the Ward’s Automotive US Auto Sales peaking at the end of 2016 to 16.58 SAAR at the end of May.

The broader implications of this trend will not be simply isolated to the share price value of auto producers as this sector is traditionally a positive contributor to US GDP growth. Looking at our second chart of the week we are starting to see US vehicle sales reversing their trend of a positive GDP tailwind and are now acting as a negative GDP headwind. The table on the bottom of the chart shows the deflationary drag vehicle prices are contributing to CPI.

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