Will The Crash in Autos Drive The End Of This Cycle?

by Jeffrey Kleintop, Senior Vice President and Chief Global Investment Strategist, Charles Schwab & Co., Inc.

Key Points

• The last global economic cycle ended with a housing bust; will the bust in auto sales end this cycle?
• Auto sales have crashed, the unsold inventory and delinquent debt may worsen well into 2020.
• This auto-led downturn may be less damaging to the global economy than the housing bust was 10 years ago, but automobile manufacturing still accounts for a sizable amount of production, debt, and jobs.

In 2009, the world economy was starting to climb out of a housing-led downturn. Ten years later, a downturn in auto production following tumbling car sales is driving a bust in manufacturing and threatening a recession for the global economy. This auto-led downturn may be significantly less damaging to the overall economy than the housing bust, but is no minor threat considering the amount of production, debt, trade, commodities, and even jobs tied to the making of automobiles. The auto inventory and debt hangover may last well into 2020.

Manufacturing-led downturn

Manufacturing output has slowed sharply around the world, slowing overall economic growth. This can best be seen in the resulting drawdown of excess inventories acting as a drag on economic growth.

• The change in inventory shaved nearly one percentage point off of U.S. GDP growth in the second quarter and may knock up to half of a percentage point from growth in the third quarter when reported this week, according to the Atlanta Fed GDPNow model.
• In South Korea, ranked near the top by the percentage of the economy tied to manufacturing, the change in inventory subtracted half of a percentage point from third quarter GDP when it was reported last week.
• In the European Union, the change in inventory subtracted more than two percentage points from GDP in the second quarter on an annualized basis, as you can see in the chart below. Without this drag, GDP in Europe would have been a solid 2.6% in the second quarter—instead of posting the weakest growth since 2013.

European Union: Contribution to second quarter GDP

Source: Charles Schwab, Eurostat data as of 10/27/19

In addition to the economic data reports, this weakness can be seen in the manufacturing surveys from Markit. In manufacturing-focused economies like Germany, the ratio of manufacturing orders-to-inventory have fallen to the lowest level since the 2008-09 global recession, as you can see in the chart below.

German manufacturing orders-to-inventory ratio pointing to continued weakness

Source: Charles Schwab, Bloomberg data as of 10/27/2019.

Autos are the driver

The automobile industry has been the main driver of the global manufacturing slowdown. This can easily be seen by breaking down manufacturing production by type.

• In the U.S., production of high tech goods were up 2.5% from a year ago in September, while production of motor vehicles and parts is down -5.4% and the output of everything else was down just -0.6%, per the Federal Reserve.
• In South Korea, a major producer of automobiles and headquarters to brands like Hyundai and Kia, auto manufacturing is down -4.8% from a year ago in August while production excluding autos is up 0.2%, based on data from Statistics Korea.
• In China, the world’s biggest maker of cars, auto production is down 8% from a year ago, while overall industrial output was reported to be up 6%, according to China’s National Bureau of Statistics.
• In the European Union, the second largest auto producer behind China, auto production was down -3.5% from a year ago in August, while production of overall durable consumer goods was up 0.4%, per data from Eurostat.

Leading the slowdown in manufacturing, auto sales have tumbled around the world. Global sales are down 6% year-to-date, according to data from Bloomberg. Growth in the world’s biggest car market, China, turned negative over a year ago, as you can see in the chart below. Year-to-date sales are down 3% in Europe, the second largest market. And, they are down just slightly in the U.S., the third largest auto market.

Auto sales growth in China

Source: Charles Schwab, Bloomberg data as of 10/27/2019.

The drop in automobile production helps explain why the German economy and stock market have been suffering. German auto demand peaked around the start of 2018…

German auto production crashes

Source: Charles Schwab, Bloomberg data as of 10/27/2019.

…as did the German stock market.

Germany’s stock market behaves like an auto stock

Cumulative total return since start of 2002. Source: Charles Schwab, Bloomberg data as of 10/27/2019.

Echoes of the housing boom

In a faint echo of the late stages of the 2000s housing boom, auto financing has become more of a burden on households and lenders in recent years.

Car prices have been on the rise. As cars have become safer, more environmentally-friendly, and offer more high-tech options, prices have climbed. Ten years ago, the average base manufacturer suggested retail price for a car in the U.S. was $23,900 with consumers adding about $6,500 in options, totaling $30,400. In 2019, the average base price has risen to $29,000 with another $10,000 in options bringing the total price to $39,000, per data from Experion. That’s a 28% increase over the past 10 years.

The higher loan balances, longer loan terms, and rising rates have contributed to rising delinquencies on auto loans, per data the Federal Reserve in the chart below. Comprehensive data exists only for the U.S., but may reflect worldwide auto loan deterioration.

Rising auto loan delinquencies

Source: Charles Schwab, Bloomberg data as of 10/27/2019.

Financing may be key

The sharp cutbacks in motor vehicle production growth have mirrored sales growth. Inventory levels may soon begin to come down if sales revive supported by lower rates and increased willingness to lend by banks. If auto sales pick back up, auto production may follow—reversing the manufacturing downturn which has weighed on the global economy and earnings.

The cause of the downturn in demand doesn’t appear to be the result of any direct impact from trade tariffs. While a proposed tariff increase on Chinese imports was supposed to take effect on October 15, it was delayed. China has also held off on its plans to implement a 25% tariff on American-made vehicles. The U.S. forged new trade agreements with Mexico, Japan and South Korea over the past year, all major sources of auto production, and those agreements did not include any new auto tariffs. The upcoming November 13 deadline for the Trump administration to issue a decision on tariffs on auto imports from the European Union, is worth watching but may also be delayed.

Instead, the pullback in demand could be due to financing costs. In addition to rising auto prices boosting loan balances, higher auto loan interest rates have made payments more costly.

• Auto financing rates rose sharply in the U.S. last year and have yet to recede, as you can see in the chart below.

Interest rates for auto loan have climbed sharply

Source: Charles Schwab, Bloomberg data as of 10/27/2019.

• In China, interest rates on consumer loans have climbed over the past couple of years, as policymakers sought to slow excess credit growth.
• In Europe, while interest rates remain low, bank lending officer surveys reveal that lending standards have been tightening for consumer loans for durable goods such as cars, making auto loans increasingly harder to get.

Rate cuts by central banks combined with potentially easier lending standards might revive auto demand at some point in 2020—if the job market remains resilient to the cutbacks by businesses. But, even if consumer spending pulls back on more than autos in 2020 and an economic recession is the result, the duration of an overhang of unsold autos on the economy compares favorably to the years it took to clear the excess housing inventory following the housing-led recession and financial crisis in 2008-09. Moreover, a potential dip in used car prices in 2020 is likely far less impactful on households’ wealth and spending than the downturn in the prices of homes ten years ago.

Will car sales rebound?

Eventually, car sales are likely to rebound. In particular, easier financing conditions for auto loans may begin to help stabilize sales. But overall weakness may linger in 2020. Over the longer-term, there is still plenty of upside to worldwide automobile demand—despite the rise of ride sharing. For example, the number of cars per person in China is only one-fourth of what it is in neighboring Japan, and well below that of Europe and the United States. This suggests that the recent drop in the world’s largest auto market will eventually be reversed—although that growth may be slower than in the past due to fewer tax incentives and new pollution-related limits on new car registrations.

In the near-term, the trade tensions remain a risk to auto production with the prospect for new auto tariffs between the U.S. and Europe and the U.S. and China to be revisited before the year is over. Political developments may also shape the outlook for 2020 with elections in the U.S., U.K., and parts of Europe and Asia that may lead to new regulations and environmental standards that could further increase the costs of new autos. Finally, a big risk is that the downturn, which started with autos and has spread from manufacturing to earnings and on to business spending, may soon begin to spread to the job market and undermine consumer spending (outside of autos) which has been the sole source of support for the global economy. So keeping an eye out for signs of deterioration in the job market around the world may be the key as to whether the auto-led slowdown can rebound or will lead to a broader downturn ending in a global recession.

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