Completing the renovation of Detroit: Transforming the auto industry
INSIGHT ARTICLE |
Ten years ago, the U.S. government sponsored an orderly bankruptcy of General Motors and Chrysler, and their lending arms during the most intense phase of global financial crisis. That bailout—fueled with roughly $80 billion in taxpayer money—forced a sweeping restructuring of the domestic auto industry and set the automakers on a path to profitability that came more quickly than even the most ardent skeptics imagined.
But few could have predicted the challenges that the auto industry faces today. From electrification to autonomous driving and changing consumer tastes, the big three U.S. automakers are grappling with profound change.
It is clearly time that they move toward consolidation and reshape the industry. But that restructuring will, in turn, hit workers as their share of production declines. Worker dislocation will require a set of policies to cushion the effects of a transformation that will only intensify following the end of the current business cycle.
Most important, the North American and global supply chains built over the past quarter of a century are not likely to be abandoned, and will become even more global, despite the radical shift in U.S. trade policy over the past 18 months. Look no further than China, which has become the biggest producer and consumer of automobiles in the world; the United States is now second. The composition of production will most likely continue to move toward a broader and deeper form of globalization.
That globalization will sometimes favor North American supply chains. Even as General Motors announced that it would close four plants in the United States and one in Canada in 2019, Volkswagen is investing $800 million to make electric vehicles at its plant in Chattanooga, Tennessee. A joint venture between Toyota and Mazda will invest in an assembly plant in Huntsville, Alabama, according to a report from the Wharton School. Ford and VW are about to start a joint venture in producing selfdriving autonomous vehicles for global production.
MIDDLE MARKET INSIGHT U.S. and global middle market firms with exposure to North American and global supply chains should begin preparing for a period of consolidation and dynamic change. The large international auto producers will begin to integrate sophisticated technology into autos amid reduced sales in the wealthy advanced economies.
All of this change is coming as automakers grapple with profound shifts in consumer taste, from the type of car to purchase to whether to opt for alternative forms of transportation. Take affordability. As new cars become ever more expensive, many consumers are opting to buy a used vehicle coming off a lease. Edmunds, the auto research firm, reported that the price gap between new and three-year-old used vehicles grew to 62%, or $14,000, in 2018, up from 56% and $11,000 in 2013. And when consumers do buy a new vehicle, they are increasingly favoring light trucks over traditional sedans (see chart), a trend that was pushed along by the 2015 oil price shock. Then there is the question, particularly among millennials and other younger buyers, of whether to own a car at all. For many in this generation who live in cities, it’s cheaper and more convenient to ride-share or opt for public transportation. This trend will continue to reshape the parameters of ownership, consumption and auto production.
Another factor influencing individual car ownership is growing awareness of the social costs of individual, gaspowered transportation. Autos, after all, are a leading cause of polluted air in cities, worldwide climate change and the accompanying health issues.
Automakers are keenly aware of these changing tastes. “We believe the future is electric, and we also believe it is autonomous, connected and shared,” said GM in its sustainability report in 2018. The company’s stated vision calls for zero emissions and it has restructured around this goal.
Ford, meanwhile, announced the electrification of its most popular U.S. product, its 20 mpg F-150 pickup truck. The move seems to sum up the state of the industry—holding onto existing customers and trends, while trying to move forward. It’s easy to be critical of the remaining automobile corporations as being too big to be innovative and too big to fail. But imagine trying to retool the Titanic in the middle of the North Atlantic.
In the end, the challenges of a changing industry leave automakers and their vast network of suppliers scrambling to adapt in a way few could have imagined even a decade ago.
Changes in automobile demand
Despite population growth, there has been a million-unit drop in U.S. light motor vehicle sales (cars and light trucks) from a rate that hit nearly 18 million per year in 2015 to 17 million in 2019. Given the prominence of autos in U.S. personal transportation, the growth of auto sales could be expected to move in sync with real gross domestic product growth. That seemed to be the case from 1979 to 2013 (see chart).
Since 2013, however, auto sales have decelerated from a 10% per year growth rate to negative growth, while GDP has been centered on a 2.3% rate of growth. There are undoubtedly multiple reasons for the decline in demand for motor vehicles, ranging from affordability— incomes have not kept up with price increases—to the higher-quality/longer-life of cars that no longer require frequent replacement.
While the current gap between GDP growth and automotive sales can be attributed, in part, to the Trump administration’s late-cycle fiscal stimulus that pushed 2017-18 GDP growth higher, there were also unanticipated changes on the demand side.
As the following chart shows, the ratio of auto sales to the population has declined steadily since 2013, which suggests the impact of longer-term demographic changes, and shifts in lifestyle preferences. As the population ages and as baby boomers retire, there is less need for two-car families. The increase in retirees (and the decrease in interest income because of extremely low interest rates) suggests a decline in disposable income and the propensity to spend. Maybe one car per household is sufficient for the older set.
As to lifestyle preferences—and at the opposite end of the age spectrum—younger cohorts are moving to cities where cars are an expensive nuisance rather than a necessity. For these consumers, owning a car has quickly been replaced by ride-sharing, bicycling to work, and light rail or bus options. (Analysts also point to a 2017-18 resurgence in auto purchases by millennials, who found themselves having babies and moving to the suburbs.)
Changes in automobile supply
The supply of motor vehicles at any one time is a function of past decisions by producers, and current decisions by consumers. The gap between supply and demand becomes overhanging inventory that drives down prices and profits. As the next chart suggests, when economic growth decelerates and disposable income decreases, the inventory to sales ratio of automotive wholesale dealers increases.
The recent sharp increase in the wholesale inventory of vehicles relative to sales appears to both confirm the lack of demand because of the global economic slowdown, and speak to the difficulty of correctly anticipating changes in consumer buying patterns and taste.
Domestic automakers have moved out of the sedan business in response to the public’s desire for sport utility vehicles and trucks. Sedans that remain in product lines are manufactured by foreign affiliates.
”Automakers’ response to consumer preference has been to shift production away from industry-relevant vehicles,” IBISWorld, a market research firm, reported in July. “In 2017, Fiat Chrysler Automobiles N.V. halted production of cars and sedans in the United States. In 2018, General Motors and Ford Motor Company both announced plans to further restructure operations.”
But retooling to accommodate current demand for light trucks might turn out to be late in the game. After all, the resurgence in demand for gas-guzzling trucks (what followed demand for muscle cars such as Dodge Chargers and Chevy Camaros) is due, in part, to the 2014-15 collapse of oil prices seen in the following chart. It wasn’t that long ago that gas shortages upended consumer preferences. In the 1970s, demand for fuel-efficient cars led to the creation of domestic models like the Ford Pinto and Chevy Vega, and the eventual takeover of that segment of the industry by Japanese imports of Toyota and Datsun, now Nissan. Ultimately, voluntary import quotas led to the growth of domestic manufacturing by foreign-owned corporations.
Although the fossil-fuel industry now operates within a global market, and although the United States now produces more crude oil than the Saudis or the Russians, further attacks on Saudi Arabia’s Aramco production facilities, the crippling of Venezuelan trade or further sanctions on Russia would, nevertheless, act to drive gasoline prices higher, with a deleterious effect on U.S. personal spending and rapid changes in transportation preferences.
Automation and labor substitution
Employment in the automotive sector has been declining with a few exceptions in the 2011-19 post-financial crisis era, falling from a 10% per year rate of growth in the number of 2012 employees to zero growth in 2019 (see next chart). As soon as the 2018 tariffs were announced, the number of automotive workers as a percent of total nonfarm payrolls began to decline, a further blow to labor in the U.S. manufacturing sector.
The International Federation of Robotics lists the automotive industry as the main customer of robotics, as the transition to electric vehicles spurs further automation. Automation would imply a reduction in the demand for labor and changes in required skills.
As illustrated in the next chart, automation took off in the late-1990s before peaking in 2016. Note that while there has been a decrease in robotic installations in motorvehicle manufacturing since 2016, installations continue to grow in automotive parts manufacturing.
The 2018 increase in the number of automotive assembly employees suggests an industry that was preparing for restructuring. Rather than spending capital on the manufacture of end-of-cycle models, it might have been cheaper to throw expendable labor at meeting increased demand for current models (i.e., light trucks powered by fossil fuel).
And if wages are determined by productivity of labor, and because robotic installation was greater in the parts sector than in motor vehicle production, one would expect greater wage gains in parts manufacturing than in vehicle assembly as seen in the next chart.
How bad is it for the automotive sector?
The global manufacturing slowdown took hold in the United States in the third quarter of 2018. The auto industry has not been immune.
- GM’s second-quarter revenue rebounded after a 9.2% drop in the first quarter. According to GM’s press release: “U.S. retail market share is estimated to be flat compared to a year ago, with trucks and crossovers offsetting lower passenger car sales.” GM also said its China divisions sold 754,000 vehicles in the second quarter, about 100,000 fewer than the previous year’s quarter.
- Ford announced a 22% decline in car sales, an 8.6% decline in SUV sales and a 7.5% increase in truck sales relative to the second quarter of 2018. Over the last two quarters, its total revenue dropped 7%, North American revenue fell 7.4% and Asia-Pacific revenue was down 50%.
- Nissan’s revenue fell 23.9% in North America and 13.1% in Asia over the last two quarters. Nissan also said it would cut 12,500 jobs.
- Honda’s total revenue increased in the last two quarters by 6.7%; however, revenue in Asia dropped 6.8% over the same period.
- Daimler AG’s revenue has fallen 9.9% since the start of 2018.
These results show that the U.S. automotive sector has undergone a slowdown in demand, with real economy indicators showing an overhang of inventory and diminished employment opportunities. This slowdown has forced automakers to make difficult decisions to restructure and retool motor vehicle production.
While signals in the real economy are mostly coincident with the business cycle, financial markets have the advantage of being forward-looking. The equity market’s price-to-earnings ratio is considered a leading indicator of future growth, with the market pushing up the price of a stock relative to current earnings if investors anticipate higher future earnings.
As the next chart identifies, the price-to-earnings ratio of the Dow Jones Industrial Average rose steadily throughout the decadelong recovery from the financial crisis before peaking at the end of 2017. In contrast, the private equity ratios for Ford and GM began declining in 2014-15, with the market perhaps at best anticipating diminished demand at the end of the business cycle and the unrealistic goal of auto giants acting like startups.
Today, the price-to-earnings ratios of Ford and GM are barely half the Dow Jones average or the likes of Apple, which is a unique combination of manufacturer and software developer. Does the decline in the automotive sector’s PE ratios suggest a lack of confidence in the profitability of traditional automotive production? And would a more nimble Ford and GM have been able to better compete within a world market and have prevented the decline of U.S. production to less than half of total U.S. automotive sales?
The United States does not have an industrial policy, but it does have the means to promote industrial activity. The federal government can create and enforce product standardization, protect the returns on intellectual capital, and promote safe production and safe consumption, all of which allow the market to decide what gets produced within a rational framework. Furthermore, the market allows for efficiencies in consumer choice based on rational expectations of product capabilities.
The U.S. judicial system has the mandate (if the government decides) to prevent monopolistic behavior, which otherwise creates an environment with reduced innovation and crimped consumer choice, and has also allowed foreign competitors to overwhelm the U.S. auto sector.
In the meantime, China’s government is actively promoting the development and sale of electric vehicles. Is there some action the United States can take while staying within the bounds of capitalism, free enterprise and market-driven choice?
The government could pursue policies that:
1. Employ displaced automotive workers in infrastructure projects to repair roads and bridges, creating a safer environment for drivers.
2. Employ displaced automotive workers in infrastructure projects that offer alternate methods of transportation. Such a policy would reduce:
- Traffic congestion
- Wasted energy and dependence on fossil fuels
- Pollution, while improving public health
- Wasted time that could otherwise be used for personal activity or other productive endeavors
3. Provide educational opportunities for displaced automotive workers (and all other potential members of the labor force) needed for high-end manufacturing. Projects such as promoting private high-speed trains and electric charging stations come to mind.
POTENTIAL EFFECTS IF TRUMP ADMINISTRATION TAXES EUROPEAN CARS
If the Trump administration were to slap a tariff on European cars, the impact on the world economy could be profound. Germany is already in a manufacturing recession, and further damage to the German auto sector could magnify the consequences of already slowing demand from China and the rest of the world. Such a tariff could mark the tipping point in the difference between slow growth and recession.
BMW, Mercedes and Volkswagen all have significant operating revenue coming from the United States:
- BMW receives roughly 17% of its revenue ($19 billion) in the United States.
- Daimler AG gets roughly 25% of its revenue ($48.6 billion) in the United States.
- Volkswagen receives 16.1% of its revenue ($44.5 billion) in North America.