U.S. Autos: Is the Recession Over?
The sector already had its recession, argues Morningstar, and key tailwinds should sustain growth through even a sharp economic downturn.
If the American love affair with the automobile isn’t entirely relegated to history, in recent years it has appeared to be veering toward a rather diffident coexistence. As more consumers opt for used cars over new, and for economical transportation over pricier expressions of style and status, the U.S. auto industry has been forced to reconsider its future.
Sadly, this was already largely true a decade ago, and certainly in 2019 — before the pandemic, computer chip shortage, and soaring inflation brought far greater adversity for this pivotal sector of the American economy.
Today, in the shadow of recent layoffs at several auto makers, and an economic recession — or at least a painful downturn — threatening to strike within 2023, why shouldn’t investors burn rubber in underweighting the U.S. auto industry in favor of allocating to more robust sectors?
Institutional investors contemplating this question must also weigh the important factors that bode well for American automakers, according to Morningstar. And there are several powerful positives to consider.
For one, that recession happened already
A February Morningstar report entitled Economy, Inventory, and EV Tax Credits Impact Auto Dealers’ 2023 argues that the worst pain may be over for U.S. automakers. “Rising rates, inflation, and recession risk are threats this year, but we feel U.S. autos already had its recession,” Morningstar states in the subtitle of the report. [JA1] In sum, the company’s analysts feel that the U.S. auto industry will sell more vehicles in 2023 than it did last year (clearing a low bar, admittedly) even if the country’s wider economy falls into full recession:
…Our view is that U.S. auto sales have already been at deep recession levels for much of the time since the pandemic hit the U.S. in March 2020 and the chip shortage began ravaging supply in mid-2021. For that reason, we see U.S. sales growing slightly in 2023 versus 2022 even if there is a recession.
The chips are up (though not quite enough)
It’s an understatement to say that the computer chip shortage has exacted a horrendous toll on the U.S. auto industry. Just how many sales has it cost automakers? The tally will hit north of 17 million, according to figures from AutoForecast Solutions that Morningstar cites in the report (10.5 million lost sales in 2021, nearly 4.4 million in 2022, and a projected 2.7 million in 2023). The chip shortage is regarded as one of the most significant factors causing U.S. light-vehicle sales to fall to 13.7 million in 2022 — the lowest total since 2011’s nadir of 12.8 million.
While it no longer makes daily headlines, the tail of the chip shortage is still plaguing auto supply chains. “We expect the chip shortage to be an issue for one last year in 2023, but we see inventory improving throughout the year…though likely at a choppy cadence,” Morningstar writes, adding:
…“Even though we think the worst of the chip shortage likely hit the auto industry in the fourth quarter of 2021, inventories have a long way to go to reach 2019 levels and are likely not going to fully recover to whatever new normal level the industry has in mind until 2024.”
The lack of factory-fresh autos sent Americans scrambling to buy used cars in 2021, causing a well-reported demand surge that (while delighting many private sellers) soon squeezed dealers even further, by increasing the acquisition cost of used inventory (and reducing the profit margin) just when they badly needed to make up lost revenue, according to the report. This dynamic hit certain companies especially hard, leaving them down but not out. “[It] has drastically reduced CarMax’s stock price,” Morningstar states (noting that this presents investors with “an excellent buying opportunity for a narrow-moat name that we rarely see as undervalued because, in our opinion, it’s a high-quality company”).
New cars yield more profit
Lots of Americans simply don’t want a used car, however — and many with the financial wherewithal to nab one opened their wallets wide to do so. This has markedly driven up new-car profits, accelerating a trend that began before the pandemic or chip shortage struck.
“The good thing about lean inventory is that no automaker or dealer has a reason to excessively discount vehicles,” Morningstar writes. “The dearth of new vehicle supply has brought tremendous pricing power to the new vehicle segments of the six U.S. franchise dealers we cover...a clear trend of massive increases in new vehicle [gross profit per unit, or GPU] and gross margin since 2019 is clear.”
The remarkable increases in estimated earnings before interest and taxes (EBIT) help illustrate this, Morningstar points out: “Before the pandemic, a really good dealer would [have an EBIT margin] in the low 4% range…[but since 2022 they’ve remained] in the 7% to over 8% range.” GM and Ford’s recent performance shows this growth. GM reported a favorable year-over-year variance contribution from pricing of $7.0 billion in 2021 and $8.5 billion in 2022, the report notes, while Ford reported $9.7 billion and $10.9 billion, respectively.
Credit is still flowing
While borrowing costs are rising, the auto financing market remains healthy at large, Morningstar notes, and its analysts don’t see a consumer credit crisis coming anytime soon. While more deep-pocketed consumers are opting to pay for their car outright, Americans are still financing more than 3 out of 5 new-car purchases, and 2 out of 5 used cars, according to the report.
It’s interesting to note that defaults on car loans went down during the pandemic, and not only due to increased leniency by institutions and creditors. “The S&P/Experian Auto Default Index hit what was then an all-time low in June 2020 of 0.40%, probably because of voluntary forbearances by lenders, but it reached a new all-time low in June 2021 of 0.30%,” Morningstar writes, adding:
The index rose throughout most of 2022 to 0.94% as of January (its highest mark since 0.99% in January 2020) but is still well below levels seen just before the Great Recession of high 1% to over 2%. Therefore, we are not worried about consumer credit health at this time.
Another reason that Morningstar see resiliency in U.S. auto credit? The slightly odd urgency that Americans seem to place on paying their car loan — even above other bills that are arguably just as pressing. (A May 2017 study by TransUnion revealed that consumers prioritized paying their auto loan ahead of their mortgage and credit cards, Morningstar notes.)
“CarMax once told us, ‘You can sleep in your car, but you can’t drive your house to work.’ We think this dynamic explains why consumers also prioritize auto loans, so we are not worried about an automotive credit crisis,” Morningstar writes in the February report. “We would not be shocked if defaults went up in 2023, given such low levels in 2021 and 2022’s trend, but we don’t expect any increase to cause a major credit contraction.”
EVs will gain momentum
Electric vehicle (EV) growth will almost assuredly accelerate in the coming years, given support from national and state legislation, as well as advances involving pricing, manufacturing materials, and recharging infrastructure.
“The federal government opened the door to more [battery electric vehicle, or BEV] adoption on Aug. 16  when President Biden signed the Inflation Reduction Act into law,” the report states. While emphasizing that it’s difficult to discern just how much of the Act’s full $7500 tax credit will actually make it into consumers’ pockets, given the convoluted rules of the Act, Morningstar believes that it could nudge many Americans to go electric for their next car. And given that only EVs assembled in North America are eligible for the full tax credit, U.S. automakers stand to benefit on another front.
Also in August 2022, the California Air Resources Board (or CARB) approved its “Advanced Clean Cars II” rule, stating that by 2035 all new cars and light trucks sold in California must be zero-emission vehicles. Naturally, this will strongly favor the use of EVs.
“We see California’s rules as a de facto national standard,” Morningstar writes, noting that more than a third of U.S. states already follow California’s rules, and it’s impractical “for automakers to manufacture vehicles that can’t be sold in certain states.”
There’s fertile ground for growth
After considering the many factors and trends that stand ready to fuel growth in the U.S. auto industry over the next decade, it’s clear why many analysts are bullish on the sector’s long-term health. It offers exposures to a variety of vital trends, from fighting climate change to adopting artificial intelligence, and even the improbable scenarios (such as breakthroughs in autonomous driving technology occurring unexpectedly soon) would likely lead to expansion of the sector.
“These are uncertain times for U.S. auto dealers with inflation having rapidly increased last year, an inverted yield curve suggesting recession, and mass layoffs in recent news headlines,” Morningstar writes in the February report. “[But] we believe U.S. auto sales have already been at severe recessionary levels, so we are not going to panic should the U.S. economy worsen in 2023. There is plenty of pent-up demand, automakers have room to discount if need be because incentives are already low, and the chip shortage means that inventories need to rise even if demand slows this year.”
While the path forward will likely be rocky for the U.S. auto sector through 2023, and possibly well into 2024, Morningstar believes investors will benefit by taking the long view of the road ahead.
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