Auto industry slowdown poses questions for overall economy
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According to recent news reports, General Motors announced that it would reduce production at its Detroit-Hamtramck Assembly plant, in addition to several others. This is potentially problematic for the economy, since auto sales have been one of the bright spots in the economic recovery following the Great Recession, with sales running near 18 million units throughout much of 2016.

Households buy durable goods such as houses and cars when they feel comfortable with their income and employment prospects, and they tend to cut back on these high-price items when the economy is souring. “As GM goes, so goes the US economy” was a phrase often uttered in the 1960s and 1970s.

While it is less true today, it is still largely true. Should we read the announced production cuts at GM as a chink in the armor of a steady, if unspectacular, economic recovery? We don’t think so.

In recent years, automakers have displayed a preference for quantity of sales over the quality of sales. By that, I mean automakers have often sacrificed price to sustain high levels of production.

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Automakers, like most producers, are constantly weighing how much to produce and at what price to sell it. Sometimes, they may choose to keep production high to maintain market share and do so by offering incentives and discounts.

This would be a reasonable strategy to pursue in a moderate economic recovery when the pie is getting larger. The problem now is the economic expansion is long in the tooth and the pent-up demand from the years immediately after the recession has likely been filled.  

According to data from JD Power, incentives now amount to nearly 12 percent of the average transaction price, up from the 10 percent that prevailed from 2010-14. Incentives, as a share of average transaction prices, have been heading higher for compact and midsize cars for some time and, more recently, these segments have been joined by the increased use of incentives in compact SUVs.

SUVs had generally been immune to these developments, given consumer preferences for these vehicles, and the segment was quite solid. That no longer seems to be the case.

Another factor supporting high levels of auto production has been the widespread availability of credit. Both commercial banks and auto financing arms have been willing to lend on favorable terms to households of various credit scores.

This is particularly true of auto finance arms, where data from the Federal Reserve Bank of New York’s Quarterly Report on Household Debt and Credit show that 35 percent of auto loans that were originated since 2012 went to borrowers with credit scores below 660 (households with credit scores below this level are considered subprime).

While commercial banks have been less willing to lend to borrowers with low credit scores, their terms for auto-related lending have nonetheless improved. The average interest rate on new car loans at commercial banks has fallen from 6.6 percent in 2009 to 4.3 percent today.

The willingness of lenders to engage in auto-related lending stands in contrast to the residential mortgage market, where non-prime borrowers continue to have difficulty obtaining mortgages.

Finally, auto sales may have been boosted in recent years by industry practices that count new cars purchased by the dealer as sales, or through the expansion of test-drives and rental fleets. There is disagreement within the industry as to how widespread the practice is, and I do not take sides in this debate.

That said, GM is not the only automaker dealing with high inventory levels. The inventory-to-sales ratio for the auto industry has been on a steady upward trend since the end of the recession and now stands at 2.3, the highest reading since 1990, outside of the Great Recession.

High inventory levels are no surprise in the auto industry, given the historical volatility of sales and the sector’s prominent role in determining the business cycle.

Inventory ratios also tend to be higher at automakers that offer more makes and models. However, controlling for these factors, we find that actual inventory levels appear to be higher than warranted.

Altogether, it is likely that the greater use of incentives, availability of credit, and willingness of automakers to hold additional inventory above historical norms reflect a preference for quantity of sales over quality. These trends have limits, as automakers cannot sacrifice margins and earnings forever.

As the saying goes, something’s gotta give. We think that time may be coming.

Recent data from the Federal Reserve’s Senior Loan Officer Survey indicate that commercial banks are tightening standards and terms on new auto loans. Long-term interest rates have moved higher since the presidential election and, should the trend continue, household debt service ratios will likely move higher.

Debt service ratios have historically been leading indicators of rising delinquency rates.

Automakers, already stuffed with inventory, may feel it is the right time to slow production and maintain margins. This isn’t necessarily bad for the economy writ large, as it may simply reflect needed rebalancing in the industry.

The challenge for us, and for policymakers at the Federal Reserve and U.S. Treasury, will be to understand whether any slowdown in auto production simply reflects a reversion to the norm, where automakers will sacrifice some quantity of sales to preserve some pricing power, or whether any slowdown in sales reflects a more fundamental weakening in household balance sheets that would be much more problematic given the length of the current expansion. 

 

Michael Gapen is the Chief U.S. Economist for Barclays. 


 

The views expressed by contributors are their own and not the views of The Hill