Where Can the Automotive Industry Go From Here? Part 1

Ivanna Hampton: Welcome to Investing Insights. I’m your host Ivanna Hampton. The U.S. auto industry is driving on a bumpy road. Automakers are dealing with chip shortages, stubborn inflation, and high interest rates. Car buyers are seeing eye-popping sticker prices, and it’s costing them more to borrow to buy a car. Right now, the industry is sitting at a fork in the road. Morningstar Research Services’ U.S. autos equity analyst Dave Whiston has written about the industry’s outlook. Dave is joining Investing Insights.

Dave, you and other analysts put together a big report on the auto industry each year. What are this year’s themes?

David Whiston: Well, 2023 obviously is a year of great uncertainty for a number of reasons. But it’s both good and bad, honestly. For a global sales forecast, we’re looking for a range between down 1% to up 3% year over year versus ‘22. The U.S. market is choppy and recovering from the chip shortage as is rest of the world. In China, you’ve got the expiration of EV incentives. Everyone is battling high inflation, of course, and rising interest rates. And then, over in Europe you’ve got massive uncertainty from the war in Ukraine.

Hampton: Well, let’s look at the chip shortage. Fewer cars rolled off the assembly line last year and sales fell to the lowest in years. Talk about where inventory stands now and maybe in a few years.

Whiston: I’ll just stick to the U.S. market because that’s my area of coverage. U.S. light-vehicle inventory has really been on a huge roller coaster since the pandemic started in March 2020. Initially, inventory was getting hurt for a while due to no production in spring 2020. Things started to recover in the back end of 2020, and then the chip shortage started to really hit in early 2021. So, putting some numbers behind that story, basically, right before the pandemic, we were, I believe, right around 4.0 million or 4.1 million units of U.S. light-vehicle inventory. And then, by September 2021, we were all the way down to 973,000 units for the whole industry in the U.S. We’re now at about 1.7 million, just a little over 1.7 million. So, we’ve been going up, and that’s great. I want to say we’re up, I believe, seven-straight months now, but we’ve got a long way to go.

Automakers aren’t going to go back to prepandemic levels because they want to keep pricing healthy. We’ve seen that with their financial results the past few years, too. Overproducing is the way to go, and I think the industry finally gets that. But at the same time, they know current levels are too low. The chip shortage, I think, will take at least through the end of 2023 to resolve itself, probably at some point in 2024 we’ll finally get to stop talking about it. But 1.7 million, like I said, is too low and exactly where we go I think that remains to be seen. But my prediction is probably something in the either very high 2 million to low 3 million range is ultimately where we’ll get, but that won’t be in 2023.

Hampton: Now, which automakers took the brunt of this inventory drop?

Whiston: The chip shortage has hurt everybody. It’s hurting everybody at different times and then maybe different magnitudes. I think initially in 2021 especially it was much more of a Detroit Three problem. I cover GM GM and Ford F, for example, and it really hurt on their pickup truck inventory, especially Ford initially, and Ford had a lot of exposure to the Renesas chipmaker plant factory fire in Japan back then. And then, we found out that actually Toyota TM isn’t all that quite as lean as we thought. They do stockpile inventory. That helped them quite a bit when the chip shortage first started. But eventually, their reserves did run out. In 2022, everyone was hurting from the shortage. But I think the Japanese automakers got hurt more. And there’s some interesting data points just to think about here, especially. And this matters for U.S. auto sales because the Japanese dominate the crossover segment, and crossovers are little less than 50% of all new light-vehicle sales in the U.S.

The Honda CRV, for example, sales were down 34% last year. Its inventory was about 14,000 units. Before the pandemic, at the end of 2019, it was 71,000 units. Another interesting data point to think about is Group 1 GPI, one of my dealers, based in Houston, they have stores in a lot of parts of the country. They had a really interesting data point on the third-quarter earnings call back in late October. They talked about their largest Toyota store. Normally, before the pandemic, that store would have 1,000 Toyotas on the lot to sell. And at that time in late October, they only had seven. So, they went from 1,000 vehicles to just seven vehicles to sell at that store. That just shows you the magnitude of how bad things have gotten. I do think as long as things don’t come out worse in terms of supply chains, I think the chip shortage, the worst of it is past. But it’s going to be a lumpy recovery. It’s not going to be a smooth upward line. There’s going to be some months where maybe inventory doesn’t go up that much or maybe even goes down a little bit. But the overall trend throughout 2023 and into ‘24, I think, will be upward.

Hampton: As you mentioned, lots had a lot of cars and then they stopped having a lot of cars. So, those new car buyers, they started heading toward used-car lots, and used-car prices soared. When are those prices expected to come down?

Whiston: There is a whole dynamic on the chip shortage that goes beyond new-vehicle sales, which is the used market, and used is ultimately a function of what’s going on in the new market, because there’s no used-car factory. You don’t crank out used cars to manufacture. It’s all a function of new-vehicle sales and the off-lease volume, and a new-vehicle lease is generally three years. So, basically, the pattern in used-vehicle pricing, it was actually interesting to see when you look at things like the Manheim Used Vehicle Value Index, history really repeated with ‘08-’09, and that initially when all the panic set in from COVID just like when Lehman first collapsed, pricing and demand all collapsed and the index goes down. But very quickly, used-vehicle prices start to skyrocket and that’s because used-vehicle supply starts to thin. And it got really bad, of course, initially in 2020, as I mentioned with new-vehicle production stopping in the spring that year. But then, when the chip shortage starts happening, used-vehicle pricing at that point really accelerated to the point that the Manheim Index got to an all-time high in January 2022. And it got so bad to the point, I’d say, that you had the rental car agencies, for example, my dealers were complaining about the rental car fleets going into auctions and buying of used cars because they couldn’t get their normal new-vehicle allocation from the automakers. And then, of course, consumers, they’re seeing new-vehicle pricing get high. So, they want to buy used, too. But the supply gets thin, the demand for used is high, and that just caused pricing to go up even more.

In ‘22, the Manheim Index did decline, I believe, eight months out of 12 months. Lately, though, it has gone up the past three months. Some of that I think is inflationary pressure, and some of that is also the spring and the first part of the calendar year, it’s a peak demand time for used cars because of tax refund season. So, I’m expecting/hoping that even though we still have inflationary pressures, the used-vehicle pricing will improve throughout 2023 after the tax-refund season but also as new-vehicle supply continues to increase as the chip shortage improves. That should help the market. I hate to use the word get back to normal because there doesn’t seem to be a normal anymore in autos. There’s always something going on, but things should get healthier and more reasonable relative to where they are now in early 2023 and the pricing we’ve seen on used vehicles in 2022. But as of now, pricing is still about 50% higher on a used vehicle than it was before the pandemic. And honestly, I don’t expect it to go back to prepandemic levels because, again, there’s no used-car factory, right? So, the used-vehicle supply in terms of the off-lease supply, that’s already set in stone for the next several years because a vehicle that, say, would have been bought on new as a lease in June 2020, that vehicle is not coming off-lease in June 2023. That used vehicle, it will never exist, and you can’t make that up. All you can do is start to improve things going forward. So, used-vehicle pricing, I think, it will get better, but it’s going to stay elevated relative to what people are used to, and they’re just going to have to accept that and then decide when they want to buy.

Hampton: And I believe you touched on this a little bit, but what’s the recommendation for car buyers since we are in a seller’s market?

Whiston: It’s funny you asked that. Because I actually have wanted to buy a car myself since the pandemic started. I mean, I’ll keep my comments high level here because I’m a stock analyst. But frankly, in my opinion, it’s not a buyer’s market. I think if you want to buy, you’re going to need to prepare to pay up. Inventory is tight whether you want new or used, and you may not necessarily get the selection you want. I mean, that’s why if you can wait, it’s probably better to wait. I personally am waiting, because luckily, we still have another car that works. But not everyone can do that. My father got in an accident, for example, a couple of years ago during the pandemic. He had to get a new car. And he waited a bit, but it worked out.

Hampton: And what’s the trickle-down effect on leasing?

Whiston: Leasing has gotten pulverized in terms of its mix of new light-vehicle sales. Before the pandemic, it was right around 30% of all new light-vehicle sales in the U.S. were from leasing. That ratio got all the way down to 19% in 2022. It was the lowest level since, I believe, 2012. In the fourth quarter of last year, it was actually 17.2%, according to Experian data. So, basically, that’s a function of a few things.

The biggest issue is just not enough inventory. So, what inventory they have, I think automakers are pushing and the dealers are pushing people to buy rather than lease. The vehicles produced are also more expensive, and it’s bringing people who are more able to spend a lot of money, frankly. And so, they’re buying these, on average, nearly $50,000 cars across the industry, which is too high of a price and needs to come down. I think automakers ultimately want to get leasing up because it creates a more consistent traffic flow for your dealers because a lease is generally three years and that means every three years you know that customer is going to need another vehicle. But in terms of it coming back to 30%, that’s probably not happening anytime soon. That will take a number of years, and perhaps maybe we don’t ever get there. I’ve heard dealers say in the past, some of them say they would rather it not be 30%. They’d rather see it’d be more like 20%, so maybe it only gets up into the low to mid-20s over time.

Hampton: The Federal Reserve started raising interest rates in March 2022 to fight inflation, borrowing costs have gone up. Could we see an auto bubble, Dave?

Whiston: I’ve been of the opinion for a long time that there is no subprime lending bubble in auto loans. I know people like to make comparisons to the mortgage crisis and whatnot, but it’s not really the same thing. The collateral profile between a house and a car is very different. So, yes, you can extend loan durations on auto loans. They have been creeping up over time, although in the fourth quarter they actually were down a little bit. I think it’s like 69.4 months on average now versus 69.6 months or something. Say, a 30-year auto loan, that just makes zero sense because of the collateral profile in question and the lender would have to be, I think, very foolish to write 30-year paper on a car. So, will the duration go up probably to help manage some payments? Sure. But maybe you’re creeping into the low 70s to mid-70s over time on average. There are 84- and even 96-month car loans out there, but it’s not a huge mix. But going to like a 10-year, 15-year, 30-year auto loan, to me that just doesn’t make any sense.

Also, if you look at the New York Fed data, looking at the credit scores on originations every quarter, the credit score is below 620 as a mix of overall auto loan originations. It’s now currently about 15%. In the years before the Great Recession, that same mix was double, almost double. It was in the high 20s. And lately, what I’ve been hearing and seeing in data, too, is that subprime lending is pulling back on autos, and some people might sound alarm bells on that. I haven’t heard about credit getting contracted more broadly for now, and to me it looks more like responsible lending than any kind of credit bubble. Like I said, the mix of subprime is down. So, I think lenders are trying to protect themselves. They probably did write some bad paper maybe in the past couple of years. Thirty-day delinquencies are rising. That hasn’t hit 90-day delinquencies yet. We’ll see how bad it gets. But what happened in ‘08-’09 I think was definitely not a normal recession, in my opinion.

Hampton: Talk of a recession has been going for a while now. Dave, you wrote that the auto industry already hit theirs. Can you explain?

Whiston: I’ll just sort of qualify here at the beginning and say I’m not saying auto sales are immune from a downturn or a recession should we have one in 2023 or ‘24. But this is not a normal cycle that we’re dealing with for auto sales. So, in 2020, I believe, sales were down over 14%. They were up about 3% in ‘21 in terms of year over year. And then, last year, in ‘22, they were, I believe, almost 8% if I remember right. It was the worst year since 2011, last year for U.S. auto sales.

So, basically, what I like to do is go back and look at a lot of historical data and put sales into in terms of per capita terms. I’ve got the data going back to 1951. The per capita ratio in terms of sales and in terms of the total U.S. population in 2022 was 4.1%. It was 3.4% in 2009 when we sold 10.4 million vehicles. We did 13.7 million last year for perspective. And then, the average for this per capita average for the century since 2000, it’s 5% even. So, if you then take some recession years like 1982 or 1991 and then apply per capita math to the current population, 2023′s population, depending on which ratio you use, between ‘82 and ‘91, you would get sales of either in the high 14 millions to low around something like 16.3 million. So, for perspective, that’s over 1 million to about 2.5 million more units sold in a recession than we sold in 2022.

Now, yes, the chip shortage is still out there. That may prevent some production. It kind of depends when the recession were to hit, should it hit, of course. But again, I don’t think it would be as bad as ‘09. That’s just my own personal opinion. We have macro people you can interview later to do recession takes. But it’s a really mixed bag, in my opinion, macroeconomically speaking. Yes, you’ve got inflation higher, rising rates. But at the same time, you’ve also got tremendous demand still for services like travel. And outside of the tech industry, the labor market still seems pretty tight.

So, again, looking at that per capita sales I’m talking about, that’s what leads me to believe and say something I would never normally say, which is that, should we have a recession even this year, I think auto sales will still go up year over year. Normally, I would never say something like that, because normally, the auto sales cycle basically you’re starting high, things are going great, and sales are really good and then various macro things happen and whatnot and sales tank. Well, it didn’t happen that way in this cycle because things were going along in the very early 2020 and they were reasonably OK, certainly better than they are now. And then, we have the pandemic hit, and then sales already went down. And as I said, they only went up 3% in ‘21 versus 2020. So, we still haven’t recovered yet from the downturn we’ve already had. And 2022 sales levels, honestly to me, they weren’t just recessionary, they were deep recessionary. So, if we have more of a mild recession, I still think there’s potential for potentially even 15 million, 16 million units sold in this country. And after the way the auto supply chain has cut costs and also given what the auto industry has dealt with the past few years, everyone would be ecstatic to get 16 million units right now.

Hampton: I believe you touched on it in this previous question, but where can the U.S. auto industry go from here?

Whiston: I am looking for sales to go up this year. I’m looking for a little bit north of the mid-14 million range for 2023 in the U.S. And as I mentioned at the beginning, global, we’re looking for down 1%, up 3%. Basically, I think the takeaway I would give to clients is that the recovery is going to be lumpy. It’s going to be choppy. I’m talking particularly about the chip shortage. It’s going to vary by automaker in terms of who is getting hurt or not getting hurt at any given time throughout the year on chips and how much can that help you get back. I mean, look at Ford, GM, last year. Everyone thought GM was crazy with their wholesale unit guidance of up 25% to 30%. But they delivered on that. Ford was, I believe, more of a high-single-digit number increase if I remember correctly. So, you’re seeing splits there, not just between GM and Ford but also between the Japanese automakers and other automakers, too. So, it’s going to be up and down, hence the word uncertainty I used to start our discussion today. But I do think the overall direction over time will be up because we’ve already had severe recessionary sales levels for U.S. autos for several years now.

Hampton: That was Part 1 of “Where Can the Automotive Industry Go From Here?” Part 2 will focus on the shift to electric vehicles. Dave will also discuss his stock picks, including one that’s rarely on sale. Thanks to Dave for his insights on the economic environment’s impact on the auto industry. And I’m thanking lead technical producer Scott Halver and senior video producer Jake Vankersen. Subscribe to Morningstar’s YouTube channel for new videos from our team. And I’m your host, Ivanna Hampton. I’m a senior multimedia editor here at Morningstar. Take care.

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