Auto industry driving toward a perfect storm
Inventory overhang may weigh on economic growth
The U.S. auto industry is facing a classic inventory overhang that is putting at risk the nascent recovery in overall manufacturing and production. The Detroit Three manufacturers have an inventory level of 87 days while total vehicle sales stand at 73 days. The rise in inventories reflects a switch in underlying demand, toward sales of coupes and sedans from larger trucks and SUVs, that may have caught the industry off guard; 64 percent of profits and revenues are driven by truck and SUV sales.
Meanwhile, rising interest rates and profit narrowing discount pricing are creating additional pressures on the industry. If not reversed quickly, this may lead to declining auto manufacturing and overall industrial production, thus placing overall downward pressure on U.S. gross domestic product (GDP).
North American production
Mexican auto production increased 36 percent on a year-ago basis, posting a record 363,687 units in March, while first quarter output jumped 17 percent on a year-ago basis. Mexican auto exports increased 33 percent by 297,571 and are up 14 percent to 750,162 units in the first three months of the year. About 76 percent of that production is sent to U.S. consumers. During the month of March, U.S. industrial production of motor vehicles and parts declined 3 percent. U.S. domestic auto production was down 15.4 percent from a year ago and stood at 553,900 units produced so far this year. Overall, U.S. auto production accounts for just under 3 percent of GDP. Canadian auto production slowed to a little over 8 million at an annualized pace.
Overall, U.S. auto sales have slowed to 16.81 million at an annualized pace, below what we expect to be the full-year trend line of 17 million. U.S. domestic sales have also slowed, to 13.12 million at an annualized pace, well below the peak of 14.25 million at an annualized pace posted in September 2015. Retail sales are down 3.7 percent on a year-ago basis with Ford retail falling 7.1 percent, Chrysler Fiat down 7 percent and GM declining 5.8 percent. Truck sales, the primary profit driver, were down 8.2 percent on a year-ago basis, while sales of cars dropped 8.8 percent. Weak topline sales along with tightening credit conditions imply growing signs of stress and narrowing profit margins ahead despite discounts of nearly $4,000 per vehicle. Sustaining a pace of sales north of 17.5 million to help clear the market would require a stronger economic rate of growth than our baseline forecast of 1.9 percent this year.
We have made the case for some time that the key risk to the auto sector was an overreliance on the use of subprime loans to finance sales as the average maturity of new auto loans has climbed to six years. During the current business cycle, subprime loans have averaged 22 percent of all sales per quarter, and in the final three months of 2016, they averaged 19 percent and accounted for about $300 billion in outstanding loans. There are currently $27.2 billion in loans outstanding to those with a credit score below 620 and another $17.8 billion with scores below 659. Two-point-three percent of all auto loans are more than 90 days delinquent in their payments, which equates to about $14.52 billion in outstanding loans. Total auto debt through the end of the fourth quarter of 2016 stood at $863 billion dollars, down from $955 billion one year ago. With lending officers indicating a tightening of credit, and the Federal Reserve likely to hike the policy rates twice more this year, this may put additional downward pressure on overall sales.
Auto equity value and inflation
Rising negative equity of vehicles (number of used cars coming to market) is another source of intra-industry stress. Manheim, which specializes in auction services for registered auto dealers, reports that 3.6 million used vehicles should roll off the market in 2017, followed by 4.1 million next year. On a historical basis, around 4.3 million should roll off leases in 2019. This will put marginal downward pressure on the price of used vehicles, posing a risk to the pace of total vehicle sales, the production of new vehicles and overall industrial production. At this point, about 32 percent of trade-ins are underwater with an average negative equity value of $4,382 per vehicle.
Used vehicle price deflation has been an issue in the industry for the past year. In the U.S. Consumer Price Index, used car prices have fallen 4.7 percent on a year-ago basis, while the Manheim U.S. Used Car Index has been negative during three of the past five months and up just 1.4 percent on a year-ago basis. Falling vehicle prices negatively impact trade-in cycles and cause lenders to tighten credit further as lenders become more risk averse due to collateral risk.
Global sales have likely reached a post-financial crisis cyclical expansion peak. Middle market manufacturing firms with direct exposure to the global sector should prepare for a plateau later this year and decline in subsequent years, despite an improving international outlook. The key is a deceleration in Chinese automotive demand and the withdrawal of Ford and GM from Europe and Russia as outlets for late-cycle expansion. Firms with exposure to the GM, Toyota and Volkswagen ecosystems should actively prepare for a slowdown in 2018-19. If the United States adopts a border adjustment tax, the German, Japanese and Korean automotive ecosystems, in particular, would all face an adverse shift in pricing models for exports into the U.S. domestic market and lose shares to the Detroit Three.