MARKET WATCH: What’s Happening? The auto recovery that everyone was talking about in 2015 has officially ended. Vehicle sales and prices are down, unsold supply is up, and lenders face huge blowback from high levels of subprime auto loan debt. With the economy at large continuing to chug along, autos can’t get out of their own way.
Our Take: Investors hoping that this year’s poor performance is a hiccup will likely be disappointed. Long-term forces such as generational change, an aging fleet, and the emergence of ridesharing services may permanently dampen the demand for vehicles. This industry may just keep decelerating until the next recession, and then—watch out!
The July numbers are just in for automakers, and the news is not good. Just days after the big auto companies were celebrating so-so earnings “beats” for Q2, Autodata’s report told (once again) a grimmer tale. GM’s light-vehicle sales plummeted 15% YOY. Fiat-Chrysler and Ford didn’t fare much better, with sales declines of 10% and 7%, respectively.
Although investors knew that a drop was coming, they didn’t know it would be this bad: Sales for each of the so-called “Detroit Three” surprised on the downside. GM and Ford opened the next morning down by between 3% and 4%.
These disappointing figures are just the latest sign that the automotive industry is in a rut. With falling sales, plummeting prices, and rising subprime auto loan default levels, automakers and lenders are struggling to find answers.
A BLEAK PICTURE
When we last wrote about autos (see: “Hitting the Brakes: Rough Road Ahead for the Auto Industry”), the industry was beginning to come down from its 2015 high. Now, the slowdown is in full force.
Sales: down, down, down. In July, annualized light vehicle sales posted their seventh consecutive month of year-over-year decline. In fact, dating back to August 2016, the industry has posted just one month of YOY sales growth.
The poor recent performance of the so-called “Detroit Three” has been a particularly ominous sign. GM has posted just two months of YOY vehicles sales growth so far in 2017; Ford has just one month of growth under its belt; and Fiat-Chrysler has seen its sales decline in each month this year.
Supply up, prices down. Meanwhile, a supply glut is hammering prices. In Q1 2017, the average unsold vehicle had been sitting on the lot for 77 days, the longest duration since the Great Recession. The average time spent on the lot has been rising YOY in each month since March 2016, the longest stretch in four years.
The market for used vehicles has been particularly cold: The consumer price index for used cars and trucks has fallen 10% since December 2013. And the worst may be yet to come. Morgan Stanley auto analysts predict that used vehicle prices could plummet by as much as 50% by 2021.
How is this possible? Because the used vehicle supply is about to balloon out even further.
To kick-start their sales after the Great Recession, auto lenders leaned heavily on leasing programs: In Q1 2017, new leases made up 31% of all new retail vehicle sales, up from just 11% in Q3 2009. The problem with this strategy is that, once the leases expire, these vehicles are placed on the used market, which hurts the value of used cars. This vicious circle is bad news for the lenders who base their lease prices on the assumed value of the car when it comes “off lease.” GM and Ford have each admitted as much in recent months, with both automakers lowering the projections for their financing units.
The only way to escape this out-of-control spiral would be to scale back on the promotions, discounts, and cut-rate leases that helped automakers climb out of the financial crisis. But of course this would be extremely painful short-term.
Bad news for rental car companies. All parts of the auto industry are feeling the pain. But rental companies like Hertz and Avis are perhaps the hardest hit of all.
A cratering used market hammers these firms, which rely heavily on resales. When new models arrive on the lot, rental companies offload their old models on the used market. Collectively, these firms must sell roughly 400,000 vehicles per year to make room for new supply. It follows that when used car prices decline, it plays out on these companies’ balance sheets. Investors are well aware of this relationship: Hertz stock is down 15% since February, while Avis stock has dropped by roughly one-quarter since then.
There’s also another dynamic at play that hurts rental car companies. When times are tough, many automakers want to step up their so-called “fleet sales” to give the appearance of high demand—and to avoid layoffs. (Sales directly to consumers and sales to rental car companies are both counted as “new sales.”) Nissan and Toyota each have made a major point of offering deals and discounts to fleet operators for this very reason. Thus, rental companies are faced with an impossible choice: turn down easy money now to keep supply relatively low, or take the deals at the expense of prices later.
Defaults rising. Additionally, a growing pile of subprime auto loan debt hammers consumers and dealers.
In Q1 2017, 3.8% of all auto loans were delinquent by at least 90 days, the highest share in four years. The total amount of U.S. auto loan debt has exploded since 2010—especially for consumers with the worst credit scores. How has this happened? Today, many auto lenders (Banco Santander SA, Chrysler's financer, being one notorious example) fail to verify borrower incomes or job histories, or even allow borrowers to “roll over” previous loan balances onto new loans. Rising default rates, combined with falling used vehicle prices, are a double whammy for lenders—which don’t earn interest on delinquent loans and earn less of a profit on repossessions.
What’s the upside of these lax lending practices? First, they enable lenders to keep lending at a time when low interest rates and record-high levels of dealer incentives have already pulled most future consumption into the present. Second, they give banks another asset-backed security to sell. (With home refis evaporating the banks need something new to finance.) In 2016, $26 billion worth of new subprime auto bonds were sold, up from $2.5 billion in 2009.
Regulators have begun imposing fines and penalties on the worst offenders. Banco Santander recently paid $26 million to settle allegations that it gave high-interest loans to consumers who could not afford them. As a result of growing regulatory scrutiny, many big banks are shying away from the auto lending business entirely. Wells Fargo, which less than a year ago was the number two U.S. provider of auto loans, slashed its lending volume by 29% in Q1 2017 according to company reports. Likewise, JPMorgan officials say that the company has drastically cut back on subprime auto lending.
As a whole, the industry appears to be tightening its lending standards. In Q1 2017, new car loans for subprime borrowers fell to the lowest level in two years, according to New York Fed data. Meanwhile, Fed Senior Loan Officer Opinion Survey data reveal that banks report being stingier across the board when it comes to auto lending.
WHAT AUTOS MEAN FOR THE BROADER ECONOMY
Of course, many observers see parallels between today’s appetite for subprime auto bonds and the mortgage-backed securities crisis that led to the Great Recession.
But there’s little indication that autos are a bellwether for the economy at large. Low credit spreads overall suggest that subprime or otherwise risky debt is not an economy-wide problem: The Bank of America Merrill Lynch U.S. High-Yield Option-Adjusted Spread is just 3.7%, its lowest level in three years.
According to bulls, the fact that these credit woes are confined to the auto industry is a reassuring sign. The good health of the rest of the economy, they say, will be enough to pull autos along. A record number of consumers are traveling again (44.2 million Americans traveled 50 miles or more on July 4 weekend, according to AAA), a trend spurred by unseasonably low gas prices and rising median income. (See: “A Good Year for Middle America.”) Additionally, annual vehicle sales are still well above recession levels.
But on the flip side, these factors should already be boosting autos. Yes, people are getting back on the road, but total gasoline consumption is no more than it was back in 2007—when gas prices were higher and population levels were lower. Ditto for auto sales. They peaked a year ago at around their pre-recession high—and are now trending steeply down. If this is the best the industry can do when the economy is rebounding, what will happen in a downturn?
LONG-TERM PROSPECTS
Even if the economy performs very well over the next year, the longer-term future for autos may be disappointing. Several drivers could be pointing to a secular downward shift in America’s demand for vehicles.
Long live the cars! For one, today’s vehicles are built better than ever. The average age of the U.S. fleet hit a record high of 11.6 years in 2016. Most old vehicles remain in use even as people continue to buy new ones, which puts a long-term drag on the industry. Looking back, the average age of household automobiles was only 5.1 years in 1969—meaning that America had to produce twice as many vehicles just to keep the same number on the road.
Ridesharing takes off. Meanwhile, ridesharing platforms pose an existential threat to car ownership. Today’s cars sit idle around 95% of the time, according to research done by public policy expert Paul Barter. But if apps like Uber and Lyft continue to gain steam, it could drastically reduce that ratio, leading to a world in which there are vastly fewer cars on the road that are driven more often. Yes, this will wear out the vehicles on the road faster. But it will mean vastly fewer vehicles on the road—bad news for automakers.
Some ridesharing users are already confirming these fears: A recent Reuters/Ipsos poll found that nearly one in ten consumers who have sold a vehicle in the past year say that they are relying on ridesharing services to get around.
It’s no surprise that automakers have planted their flags in the ridesharing business (if begrudgingly). GM now owns shares in Lyft; Toyota is a stakeholder in Uber; and Volkswagen pumped $300 million into ridesharing competitor Gett. The same goes for autonomous vehicles, which are expected to play a huge part in the ridesharing revolution. Ford recently announced that it is tripling the size of its driverless test fleet this year, while GM stands to benefit from a new partnership between Lyft and self-driving technology developer Waymo.
Automakers have been publicly championing these technologies, but not because they really want them to succeed. (You’d have to be crazy to earnestly labor on a new paradigm that will render your product largely obsolete.) Nor do these firms really believe that self-driving cars will be pulling up to your driveway anytime soon. An assessment we agree with: See “Driverless Cars: Unsafe at Any Speed?”
So why are they doing it? For one, it looks good for your brand to be embracing this cool and green cutting-edge technology. But more importantly, taking a stake in this futuristic industry is a contingency plan. If and when self-driving cars do come to market, each automaker knows that it will leave room for only one—or maybe two—traditional car companies. And each wants to be one of these survivors.
Eventually, yes, these technologies will arrive. And when they do, it will likely be a career-ending moment for most of the players in the industry.
Millennials just aren’t that into you. Perhaps the largest drag on Big Auto going forward will be generational change. Boomer and Xer car enthusiasts are rapidly ceding ground to Millennials, who just don’t care about car culture like their elders still do.
Plenty of media outlets proclaim that Millennials are storming into car ownership. And yes, young adults are spending more on vehicle purchases than they were a few years ago. But they’re still spending less than Xers did at the same age. According to BLS consumer expenditure data, just 9% of the average 25- to 34-year-old’s expenditures went toward vehicle purchases—down from 11% in 2000. That hardly points to a Millennial resurgence in car ownership.
What’s more, when they do buy cars, cash-strapped Millennials increasingly are opting for leases (which we’ve already established as a problem for automakers) rather than outright purchases. Fully 32% of new car buyers under age 35 leased their ride in 2016, the highest share of any age group—up from 21% in 2011. In addition to cost constraints, Millennials are drawn to the non-committal nature of a lease, which allows them to try out another model in a few years’ time. And then there’s the theory, floated by some media outlets, that Millennials could even be buying cars for the express purpose of driving for Uber or Lyft. Given this generation’s love of “side hustles,” we certainly can’t rule this out.
The message to investors: Autos are clearly on the downside of their recent cyclical expansion—and a full recovery is unlikely anytime soon.
