The shifting winds in the US auto sector

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In case you missed their publication on 14/06/17, 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%.

A new musty smell in the US retail sector

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.

We sequence the cycle in credits sectors within fixed income debt

On our fixed income 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 lead to a stable trade cycle for used vehicles and in turn stable new car sales velocity, this, at the end of the day, translates into positive contributions to GDP and Consumer Price Indexes (CPI).

The majority of new vehicle transactions involve the trading in of an old vehicle. A healthy market for used vehicles 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 US leasing market for cars is driven by residual value

The leasing market is driven by “residual value”, that is the lender’s estimate of what a vehicle’s value will be at the end of its lease. Residual value is almost exclusively determined by current and forward estimates of used vehicle prices. Therefore, the lower the residual value, the higher the monthly lease payment. New and used car buyers are price sensitive to monthly payment amounts.

Auto producers use incentive programs to prop up sales of cars

When current used car values start to fall, future residual value falls. As a result, new vehicle lease payments will increase and new vehicle sales will slow. In response 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% since May 2016 with 26 consecutive months of increase in incentive spending.

Incentive programs only delay the inevitable…

But this strategy only delays the inevitable as used car prices continue to fall under the weight of vehicles comming off lease.

Last year, 2016, saw off-leasing of 2.8 million cars. We expect this figure to grow to around 4.8 million by 2021.

The inevitable being a fall in new vehicle lease sales

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. Exhibit 1 shows exactly this with the Ward’s Automotive US Auto Sales peaking at the end of 2016 to 16.58 Seasonally Adjusted Annual Rate (SAAR) at the end of May.

Exhibit 1: US auto sales (total annualized SAAR) are falling, suggesting that incentive programs are no longer offsetting the decline in used vehicle values

US auto sector

Source: Bloomberg, as of 31/05/2017

Conclusion: Vehicle sales are now a drag on both US GDP and CPI

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. Exhibit 2 below shows that we are starting to see a reversal of the trend whereby US vehicle sales acted as a  GDP tailwind. They are now acting as a GDP headwind.

Exhibit 2: The positive contribution auto sales were making to year-over-year CPI growth is falling

US auto sector

Exhibit 2 bis: Auto sales are now detracting rather than contributing to quarter-over-quarter GDP growth (in bps)

US auto sector

Source: Bloomberg, as of 31/05/2017


Written on 26/06/2017

Dan Singleman

Senior Portfolio Manager, Sector Rotation

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