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Monday, October 24, 2016

Is Brexit a Risk to US Growth?

mike smitka

I made a short presentation as a component of board education for a local bank. The president was curious about Brexit, so I used that as a point of departure. What follows are thumbnails of slides; I add several at the end that (as expected) I did not get to during my talk.

First, I began by emphasizing that there is no business cycle, as emphasized in a previous posting on this blog. By chance in the immediate aftermath of WWII the US had 3 recessions with similar timing, but that's not happened since. Just because we've gone 7 years without a recession doesn't mean that one is more likely in the next year. Furthermore, the apparent causes vary, so predicting on the basis of past recessions is pointless. Now once a recession has begun, then certain changes occur – but those can also arise without a recession being underway. So it is possible to calculate recession probabilities, but those are weak and at best provide information on the next several quarters.

Still, we can think about potential threats. Is Brexit one? A quick look at recent data suggest "no". The pound has depreciated by about 25% and because the UK is relatively "open" – trade is about 1/3rd of GDP – that will result in some uptick in consumer prices. But so far that's been modest (from 0% inflation to 1% inflation). Meanwhile, unemployment is falling, not rising, and there's no evidence so far of a slump in GDP growth. Meanwhile, interest rates remain at zero. No surprise there, that's been true of the developed world thanks to the Great Recession, and the stalwart refusal of most countries to use fiscal policy.

Even if British growth does slow, that has only a modest impact on us, the US, because the UK is a modest part of the global economy, at a bit under 3%. Now if problems there hurt the remainder of the EU, then that starts to change – the EU is bigger than the US, but it's still only about 1/6th of the world economy. If we are worried about flash points, then we really need to look at the rest of the world because growth in the developed has been slower than elsewhere. NAFTA comes to only about 20% of the world economy; add in the EU and Japan and the developed countries are now less than half of the global economy. That's good news, the more the better for everyone. But we need to pay attention to China. No more on that here

Meanwhile NAFTA as a whole is doing relatively well, with the IMF projecting 2017 growth in all three member countries at over 2%, higher than the UK or any of the larger continental economies.

We do however need to set concerns about the future in context. Due to demographics, growth in the US will not hit 4%, no matter what politicians do. The baby boomers are retiring, and so we have very low labor force growth. While we still have slack, we are now – at long last – approaching historic levels of labor utilization. Indeed, I'm slightly hopeful that with the numbers of those working involuntary short hours is now close to historic levels more of demand will serve to pull those prime-aged Americans who dropped out in 2008-9 back into the labor force. So we can continue to grow at 2% for a couple years, but then things will slow, independent of whether the Fed raises interest rates.

The graphs below present several snippets. The first is the "broad" measure of unemployment (the black line, U-6) relative to the "headline" level in green. It's still high, but at least close to the level of the better time periods since 1994. (Consistent data aren't available before then.) Second, we can see the loss and now addition of jobs, all relative to my calculation of the number of additional jobs needed to keep up with population growth, net of "boomer" retirement. The third graph is a variant on the second one, looking at jobs relative to my attempt to calculation a "normal" baseline. Finally, there's age-specific participation, which continues to be well below normal – if we extend back before 2007, these curves are all flat. (That does hide other dynamics, such as a drop male participation prior to 2007 that is offset by a rise in female participation.) This graph suggests that we have further to go until full recovery – I'm hopeful of end-2017, but project participation and it's 2019.

Now the Rockbridge Virginia region is not average; we depend more on retirement and tourism, and construction. The bad news is that for the nation as a whole housing starts have been falling relative to the population for the past 50 years. We may not see an uptick at the national level. But the good news is that the CoreLogic data on mortgages shows the share with negative or near-negative equity has fallen from almost half of all homes to a quarter. Most of that has been due to the drop of those with negative equity, either because over time the combination of higher housing prices and the repayment of loan principle has pulled them into the 80%-100% loan-to-value bracket, or because due to foreclosures there are now new owners. Since as a small bank you do hold some mortgages on your books, that is reassuring, and it's even better that net homeowner equity has risen by over $4 trillion since the start of 2013.

What happens locally is however more a function of whether retirees in nearby urban areas can sell their houses and buy a new one here. House prices in the mid-Atlantic region aren't uniformly above the bubble peak of late 2006, but Charlotte and Atlanta are close or positive, and the Washington DC area looks pretty good relative to much of the country. You can find all that data on FRED. Finally, my work is on the auto industry, and car (or more accurately) light truck sales are strong, but that does imply you should not expect much upside. With only one dealership left in the county car loans may not be a big part of your portfolio, but don't look at them to grow except as you increase market share. Production is strong, too, despite the bad-mouthing of NAFTA. The plants of Lear and Dana are long gone, so that's less relevant, but it is consistent with the picture of sales near their peak, reinforced by sales per person working back around 0.14 (scaled by 1,000).

Finally, what of interest rates? We should not expect the Fed to raise them quickly, or far. For the past 25 years interest rates have been falling. Some is that for the US as a whole inflation has fallen, and expectations seem to have gradually factored that in as a permanent change. Ditto in the major trading partners with whom we're linked financially, several of whom are actually experiencing mild deflation. In addition, it seems that despite all the hype around Silicon Valley, investors aren't expecting growth to pick up, either. Long-term interest rates are at 3.5%. We should take that with a dose of salt, as they've seldom been a good predictor of things 20 years hence. But if we return to 2% inflation, that means those in the bond market are factoring in growth of at most 1.5% (we surely need to deduct a risk premium, in which case growth and/or inflation must be lower).

Now I didn't include yield differentials. Those are quite volatile – the yield curve moves around a lot – and are neither high nor low today. So if the profits of a bank come from using short-term borrowing (including deposits) to fund longer-term loans, there's nothing to indicate conditions today are unusual. Have me back in a year and I can likely talk about the empirical evidence of interest rate normalization...

October 20, 2016

Friday, October 7, 2016

Jobs Update in 3 Graphs

The long, slow recovery continues. First, participation by prime-age workers continues its increase, as does that of those aged 20-24. These demographics bore almost all of the job losses in the Great Recession – I don't include it, but older worker employment actually rose, the "boomers" didn't retire the way their parents did. The same story shows up if we look at the gap between my calculation of expected levels of employment, given boomer retirement, and current levels. Indeed, the number of workers on short hours is now back to historic levels, good news as any strengthening on the demand side will be more likely to turn into new jobs rather than an increase in hours for those currently working.

Now the main focus of this blog is on the automotive industry. While it should not be surprising, given the likely peak in new vehicle sales, the rise in manufacturing employment has slowed if not stopped. But manufacturing jobs are affected by the continuing increase in productivity over the past 20 years. Fifteen years ago automotive manufacturing accounted for a full 1.0% of all jobs in the US. Now that level is peaking at 0.6%. Now the industry has added many software jobs, and will continue to do so to support new safety technologies and infotainment functions.

These data do not capture such employment. Our statistical systems were set up when manufacturing and construction were keys areas of employment, while healthcare and other services accounted for relatively modest shares. Bringing our data systems into the 21st century will require boosting the budgets of our statistical agencies. From the standpoint of the overall budget that expenditure would not even constitute spare change. However crucial such data are to business planning, there is no "business" lobby on Capitol Hill that can speak to such issues, and instead these agencies face budget cuts. It is not just physical infrastructure that is deteriorating, it is also some of the other hidden areas that our economy depends upon that need to be improved.

Monday, October 3, 2016

Domestic Automotive Jobs: NOT the Sept Monthly Sales Report!

Domestic Vehicle Production
Domestic Industry Revenue

The domestic US auto industry has by two metrics finally recovered from the Great Recession. The first two graphs present total industry output in unit terms and in revenue (deflated by the producer price index for motor vehicles and parts). Both are at the highest in 40 years. The industry has never surpassed the boom that immediately preceded the First Oil Crisis.

I remember that era well. As a college student in the summer of 1973 I worked at Chrysler Mack Stamping. Monday-Friday I worked 10 hour days, and to that added two 12-hour shifts on the weekends. For my 74 hours, between "regular" overtime and double time on Sundays I earned 96 hours pay. Anyway, it may be just as well that we've yet to repeat that level, as the boom (which coincided with booms in Japan and Europe) helped give rise to high inflation and the First Oil Crisis.

However, the level of manufacturing employment remains well below peak, as shown in the graph below. But that reflects productivity improvements: relative to 40 years ago, we need 40% few workers to produce the same number of vehicles. That's the graph at the bottom.

In every industry with which I'm familiar [the possible exception is garment production], over time manufacturing labor productivity consistently outstrips demand. Auto manufacturing jobs aren't going to return, ever. But the same is true for manufacturing jobs more generally. Now this shouldn't be surprising. Our population has more than doubled since 1945, but we today need only 30% as many farmers to feed us whiling generating a substantial surplus for export.

Oh, and China is undergoing the same transition: farmers are increasingly redundant, while factories are shedding workers as the economy moves away from labor-intensive goods.

Domestic Industry Employment
Domestic Auto Manufacturing Labor Productivity

Saturday, October 1, 2016

Who Owns the Cars? The Billion Dollar Problem with Autonomous Taxis

Written by Maryann Keller, Principal at Maryann Keller & Associates
reposted with permission from a September 12, 2016 post on LinkedIn

The Uber business model is brilliant: private citizens use their own cars as taxis and Uber takes a piece of the fare for arranging the ride via the Smartphone Uber app. Uber avoids vehicle depreciation that piles up with miles driven, maintenance expenses (that can include damage done by passengers), and insurance. Although Uber now leases some cars to its drivers, essentially the company has been built on an asset-light balance sheet that has enabled it to avoid the messiness of buying, maintaining, and disposing of vast numbers of vehicles.

But how will that work with driverless autonomous cars that eliminate the people who are currently shouldering the responsibility for the majority of vehicles in Uber’s, Lyft’s and similar providers’ fleets? Even if these companies can avoid the inconvenience and investment of vehicle assembly, they, or another entity, would still have to own and maintain their fleets.

Having spent twelve years as a Board Member of Dollar Thrifty, the car rental company, I am well aware of the capital and operational investments required to manage a fleet of a hundred thousand or more vehicles. And those needs don't change even when the cars are driverless. In fact, the car rental model approximates what ride-sharing on a large scale requires. (For the moment we won’t consider the issue of why a rental company would take on the costs on behalf of the “app” company when they could probably build their own similar app.)

Cars, whether autonomous or not, cost a lot of money which has to be paid to the manufacturer before they go into a fleet. A small fleet of 100,000 vehicles at $40,000 per unit amounts to $4 billion that would have to be paid by some entity.

Dealers and private individuals purchase essentially all “out of service” rental vehicles which still offer many years of useful life. But who is the buyer for a used autonomous car that was probably designed specifically for the ride share company? There isn’t much demand for “out of service” taxis so we would have to assume that autonomous cars stay in service until they come to a mechanical endpoint.

The next issue would be maintenance. There is a myth among some tech geeks that electric cars don’t need service. Tesla has demonstrated that in fact they need maintenance. Despite all the sensors and millions of lines of code and a large battery, they still have wheels and tires, brakes and other mechanical parts and fluids that require replacement or adjustment. And the moment you put people into a car, even one devoid of controls that passengers can mess with, things will happen.

That’s why rental car companies are so diligent in assessing and charging for new damage done to the vehicle whether it’s the Starbucks coffee spilled on the seat or the new door ding from a runaway luggage cart. Before any car is re-rented, it is washed and checked and all cars in a rental fleet are always monitored for scheduled maintenance at the rental company’s service area. In today’s Uber world, that’s all taken care of by the driver as an owner/operator. But in a driverless world that means a depot of some kind where the cars are marshaled, serviced and cleaned which in turn requires land, personnel, equipment, and associated expenses. Even if this was outsourced, it is still a cost that has to be factored into the profit model of the ride share company.

So far, the autonomous car advocates have focused on whiz-bang technology and the ability to summon transportation with a tap on the app. But the economics of autonomous cars might limit their appeal only to major metro areas, like Manhattan, where the monthly rent for a garage space would pay the mortgage on a nice home in other parts of New York State. They are, after all, cars that have to be acquired, serviced, repaired, insured and depreciated thereby transforming the asset light balance sheet of an app company into something more akin to that of a rental car business.

Wednesday, September 28, 2016

How TrueCar and other Third Party Auto Retail Vendors Work

by David Ruggles

How do the third party vendors like TrueCar, and the others, actually work? It’s really quite simple. The auto buying Consumer belongs to retail Auto Dealers. They have the money invested in inventory. They have substantial investment in facilities. The third party vendors spend large amounts of money to “hijack” those auto buying Consumers and take them “hostage.” They then “ransom” them back to the Dealers for a sizable chunk of change. In the case of TrueCar the “ransom” is about $400. on a new vehicle and $300. on pre-owned. That money is reinvested by the vendor and used to “hijack” and “ransom” even more car buying Consumers. They are able to “hijack” these Consumers by pretending to protect them from the Auto Dealers, as if the Consumers are helpless sheep. These vendors don’t lead their message to Consumers with the fact that they raise the cost of the Dealer’s sale, and the Consumer’s purchase price, by the “ransom” amount. How many consumers would knowingly pay an upfront fee to these vendors?

The ultimate customers of these third party vendors are the Dealers. That’s where their revenue is derived. Most Dealers understand what’s going on and aren’t happy about it. A large number of them, however, have capitulated. Others use the third party vendor strategy in their favor without paying for it. For example, a TrueCar customer can come to a Dealership that isn’t a TC Dealer. That Dealer can go to the TC site and use the information provided there as a closing tool to negotiate the deal with the Consumer. Because the non-TC Dealer’s cost doesn’t include the “ransom fee,” the Consumer potentially gets an even better price while the dealer makes additional profit if they split the unpaid “ransom fee.” The Consumer becomes a higher value owner to that Dealer.

All Dealers have advertising and marketing budgets. These third party vendors would like everyone to believe that their fee would be spent in other areas of advertising rather than adding to the cost of individual the vehicles sold to Consumers the vendor took “hostage.” The vendors insist that their services allow dealers to target their marketing efforts better, thereby providing savings. The fact of the matter is that Dealer advertising budgets have done nothing but rise since the proliferation of third party vendors came into being. The Internet has spawned so many “leads” that Dealers are now struggling to figure out how to “weight” them, to distinguish leads in terms of “likelihood to purchase.” Despite the fact that TrueCar has yet to make a profit, despite reaching a Dealer saturation point that they used to claim would make them money, many third party vendors DO make money. They make enough money that there is about to be a flood of new major players enter the field.

In particular, enter Amazon Vehicles, with pockets deeper than any of the existing players. They will potentially have the budget to do almost anything they want. Indeed, they can afford to fritter away a lot of money figuring things out. Relative to stand-alone players they can lose money for an extended period of time, in a market where profits are already diluted, all the while using their competitors as “pricing cover.” Dealers could call a halt to all of this by just saying no, but while a few may hold back, enough will participate because they just don't get it, and their rivals down the street will join to make sure they don't gain an advantage. So collectively they won’t say no. There will be further consolidation in this business as players with really deep pockets enter the fray. In the meantime, neither Consumers nor Dealers will be well served.

Tuesday, September 27, 2016

Do the "Jobs" Arithmetic: Trump Calls for 19 million Immigrants

mike smitka

In the first presidential candidate debate Donald Trump proposed creating 25 million jobs. Now currently 152 million people are employed in the US, out of a potential labor force of 156 million. Yes, we're short – by 4 million jobs. Now because of baby boomer retirements and lower birth rates over the past 20 years, the size of the potential labor force will rise to only 158 million by February 2021. So while he could oversee an economy that creates 6 million additional jobs, the only way to add 25 million new jobs would be to bring in 19 million working-age adults from outside the US. Yes, Trump must be pro-immigration.

...Trump can only add 25 mil jobs by bringing in 19 mil immigrants...

There are other, less palatable alternatives, such as instituting a draft of all 22 million youth of high-school age. Since relatively few of them work or have family responsibilities, that could get him to the 25 million level.

So let's assume instead that he's not engaged in sophistry but is instead being sophisticated. That is, he's arguing about GROSS job creation, not net new jobs. In 2016, on a monthly basis about 5 million people leave their jobs, voluntarily or otherwise, and 5.1-5.2 million people are hired, in what to those individuals are new jobs. Then all Mr. Trump proposes is 5 months hires at the normal rate. Using this metric, over 4 years he needs to create not 25 million but 250 million jobs.

Now does everything Secretary Clinton has said on the economy during her decades of public life make sense? Unlikely! We all spout nonsense on occasion. But she does have staff, listens to them, and mainly gets things right. Once Trump proposes actual policies, I'll look at her proposals. But so far all he has are sound bites that don't add up.

Thursday, September 15, 2016

4% Growth?! – Trump channels Bush's 2015 pipe dream

mike smitka

Just a quick cross-reference to a February 2015 post on this topic, "Promises versus Deliverables: Jeb Bush and 4% Growth". The argument that 4% growth is unrealistic is even stronger than it was 18 months ago, as labor market slack is less. We do not have 25 million Americans just waiting for a job to be created. Here is the latest update with data through the September 2016 employment data release of my periodic projection of actual vs "normal" employment levels, where the latter is adjusted to reflect the slowdown in population growth including the retirement of the "boomers."

Wednesday, September 14, 2016

A Puzzle: long-term interest rates

mike smitka

I'm hesitant to post this graph: rates are volatile and I know that looking for trends in financial markets is silly. OK, provisos out of the way. But I've faced a puzzle for the past several years in the flatness of the yield curve. Comparing the difference in rates at various maturities, say between 7 year bonds and 10 year bonds, allows us to calculate the implicit return investors expect to have on a 3-year bond in 2023, some 7 years hence. I normalize all those into equivalent one-year bond rates. Here, that means the rate that you need for back-to-back purchases of three 1-year bonds to make the total return of a 7-year bond and three 1-year bonds equal to that of a 10-year bond.

The puzzle is that such returns have been very low. In the example I just gave, the dark brown line in the graph on the right, that's been below 2%. Are investors really rational in a belief that nominal interest rates will still be below 2% in 2023, due to some combination of (very) low inflation and very low growth? And what of a risk premium? – investors also have to believe there is no downside, that the "tail" of the distribution doesn't include bad outcomes for bondholders!

Now there are surely institutional reasons why certain maturities are focal points, for example there may be classes of investors who want bonds maturing in 2023 to match a need for liquidity at that point, and others who want bonds maturing in 2026, arbitrage possibilities be damned. Markets for intermediate maturities may be thin, so that you pay a penalty for trading non-standard paper. Traders also have finite time, and cannot follow everything, even with computers as aids. Senior managers certainly aren't inclined to spend their time thinking through whether they should be "heavy" at a maturity 8.7 years, and then explaining that to the Board. In sum, focal maturities are convenient for many reasons. But to me it's still a puzzle.

Again, it's only been the past two weeks that things have changed, too little to be meaningful in either duration or magnitude – see the graph providing data for the past 2-odd years on the bottom left, which shows many such blips. But likewise note the graph on the bottom right, which tracks the implied 1-year rate 7 years out since 1990. What we are seeing has no precedent over the past quarter century. Why anyone would buy a 10-year bond that yields under 1.75%? Yes, the Fed can push short rates down. Yes, they hold a lot at longer maturities, the result of quantitative easing – in which they no longer engage. Yes, other central banks around the world have been or are engaged in QE while pushing short rates into negative territory. Perhaps with the rich world aging there really is a demand for the "safety" of bonds that is "outstripping" supply to generate low yields? I remain puzzled.

Why anyone would buy a 10-year bond that yields under 1.75%?

Friday, September 9, 2016

Evolution or Revolution? Yes, and Margin Squeeze

mike smitka

When it comes to claims of technology revolutions, I'm reminded of The Who's song:

Won't Get Fooled Again

I'm in the last stages of reworking a book manuscript co-authored with Peter Warrian on the auto industry viewed through the eyes of technology (we're currently rewriting each others chapters). The final chapter will examine autonomy, electric vehicles and new mobility services. I think the bottom line is encompassed by a simple question: will these raise total revenue? The answer to me is so obviously "no" that I won't spell it out, at least here. But the flip side is also clear: will it raise costs? It already has, and those costs are incurred up front: financial analysts, to your net present value calculations! But (almost?) all auto assemblers believe they must play this expensive game. We have a classic prisoners dilemma: if you don't spend money, you will lose out very big [and your board of directors will replace you]. If you spend money, your firm loses big [and you're around to receive another bonus].

...only one question matters: will industry revenue rise?...

Is there a way out? Perhaps, if OEMs can turn to suppliers to fund most of the R&D. Some of these are new entrants who are convinced it's worth paying up front to gain a seat at the table, or are soft in developing the business case (only a billion? not enough money to worry about). Or both. This is the same prisoners dilemma story, but OEMs may not have to pay the cost. However, the supply chain is also quite concentrated for such technologies, with a (global) Big Three in many sectors (eg, power control modules for electric vehicles). In my observation (backed by sitting through a smattering of internal business case presentations) these firms are more hard-nosed about funding R&D projects, hoping to recoup those that pan out (and pay for those that don't) through the high prices of early systems (which in turn are on luxury vehicles). However, they may maintain the ability to pass costs on to their OEM customers, that is, keep margins from compressing quickly. My bottom line is thus that OEM margins will get squeezed. The disappearance of the Chinese sugar daddy will accentuate that.

...OEMs are trapped in a classic prisoners dilemma: doomed if they do, really doomed if they don't...

More in teasers as the book content gets nailed in place. If all goes well it will be out in November.

For those unfamiliar with the PD (Prisoner's Dilemma) game, here's the basic 2-player layout:

New Technology Rat Race
Profits Relative to Starting Point
 Don't JoinJoin
Don't Join0, 0-10*, -2
Join-2, -10*-7,-7
If no one plays the game – the upper left box – profits equal the currently prevailing norm. If one plays and the other doesn't, then the player incurs costs greater than net revenue gain, but the non-player loses revenue, which in the auto industry results in a more than proportional loss in profits. Those are the upper right and lower left boxes. If both play the game, neither party sees a net gain in revenue, because these technologies don't expand the size of the overall market. However both see costs rise and hence profits fall.
The longer the lead time before new technologies actually affect sales – under the assumption that not joining the race does eventually cost sales and hence profits – the smaller this asterisked "-10*" loss will be (in absolute value, that is). Similarly, the greater the R&D share born by suppliers, the easier it will be to join the game at a later stage, improving the net present value (or here, reducing the net present loss!). If it becomes a loss of (say) -5, then it would be rational to stay out of the new technology game. If both players are rational in this narrow net present value sense, then we end up with no one entering the technology race, and are in the uper left box. However, I am not aware of any major firm that believes that to be the case, though in reality what really matters is likely the perception of the board of directors, many of whom are industry outsiders whose beliefs are influenced by the media hype around Tesla and Uber and Google's autonomous vehicles. After all, these decisions aren't made by some abstract entity called "the firm" but by individuals affected by career and reputational considerations. For examine, a director will face queries by their golf partners, and can boast about their firm's efforts rather than hem and haw about why there are none.
One final consideration: the above analysis is for 2 players, but the auto industry has multiple players, with for example 6 firms surpassing global production of 6 million units in 2015. I don't know the theory of n-person games; my assumption is that you need stronger assumptions to find a clear solution, but the standard PD result dominates. I've not systematically studied game theory – it wasn't part of the standard curriculum when I was a grad student, though I audited a one-term course in 1985 or so. My sense, however, is that introducing noise makes dilemma outcome more likely: as the likelihood that one player breaks ranks increases, so do the incentives for others to follow suit. My bottom line:

...OEMs are on a slippery slope, and it's started raining...

Friday, August 19, 2016

Durable Goods and Used Car Prices


Elizabeth Platt, May 2016. Reposted from the Econ 244 site.

As discussed in class, an automobile value depreciates as soon as it’s driven off the lot. A recent study using iSeeCars.com puts a number to that depreciation. Analyzing 15.7 million cars over the course of the year, the study finds the average car value loss is 17% of its value in the first year. However, individual models differ in their value loss. At the top of the spectrum, the Hyundai Genesis loses 38.2% of its value in the first year.

The study cites demand as a function of reliability, popularity compared to competitors, dependability, repair costs, and redesigns. Thus, many of the factors the study believes determine demand cannot be estimated until at the time of the purchase, making resale value more difficult to gage. The drop in value after the first year corresponds to a potential savings of $16,000 if the consumer purchases a slightly used model. Consumers have the option of buying a new car with little knowledge of its reliability or waiting a year to purchase a slightly used car with more information in one hand and savings in the other. One significant part of demand, though, is aesthetics. By waiting for a slightly used car, the consumer runs the risk the manufacturer may introduce a newer model. In a society centered on “keeping up with the Jones,” newer models make the option of a slightly used model unappealing to some consumers. On the other hand, not all cars depreciate at this magnitude, making a slightly used model less of a deal. The study found some models lose less than 10%, such as the Subaru Impreza which lost just 3% of its value in the first year. In the end, knowledge concerning the difference in value of a new and a used car can be extremely beneficial for the consumer.

UsedCarsSource: https://www.washingtonpost.com/news/get-there/wp/2015/01/21/the-best-bargains-for-buyers-looking-for-lightly-owned-used-cars/

...there is no such thing as a new car...

Chart by the Prof using data from the auto auction firm Adesa. These data are raw averages of varying mixes of vehicles. Tom Kontos, their chief economist, analyzes this in much greater detail, by brand, like-vehicles, with seasonal corrections and on and on.

The Prof's comments: This is a neat topic, because the physical depreciation of a car is different from the economic depreciation. It is also at least in part a strategic variable that car companies can influence, through adjusting competition among vehicles in their model lineup and the timing of new model introductions and (as noted below by Michael Adams) fleet sale and leasing policies.
The overall declining trend is a reflection of the Great Recession: no leasing and few sales of new cars and lower incomes led to a dearth of used vehicles amidst greater demand for generally less-expensive used vehicles. That effect lingers but has largely worked its way through the system. You can though see changes by category, e.g. trucks vs smaller cars. I don't know the impact of interest rates on the "yield curve" of cars. Lower rates make both bought-new and bought-used cars less expensive, at least for purchasers who are thoughtful about their financing options. Companies such as ALG that are involved in leasing surely model that. My hunch is that the income effect – higher purchasing power – offsets the substitution effect so that there is no net impact.

Comment by Michael Adams: This article helps to explain why firms, notably General Motors, have begun to scale back on fleet vehicles. The slightly used fleet vehicles, depreciated during their time of service, are quickly resold as used cars and compete with brand new models. Consumers can reap the benefits of a purchasing a gently used car if they are willing to wait for even a few months.

Murray Manley commented: I think this article is particularly interesting because it highlights the difference in some examples of consumer and producer preferences. For example, producers are always working on producing the next model and aiming to engineer the best car that matches or exceeds the car of competitors. This “keeping up with the Jones’s” in the producer and manufacturing world leads to increased profits- whoever can produce the best vehicle the fastest will ideally sell the most cars. On the other hand, while some consumers prefer to always have a new and fashionable model of a car, others cannot afford, don’t care about, or are unaware of style changes from year to year. In that respect, the customers who care less about new models benefit because slightly used cars will always be significantly cheaper if producers continue to come out with new models quickly.

Tuesday, August 16, 2016

Visit to Fox Recycling

Prof Mike Smitka

composite of student blog posts

In May 2016 I led students to Detroit, where we visited a wide array of auto-related businesses, as well as seeing something of the city and talking to residents (Tyree Guyton of the Heidelberg Project) and Martin Lavelle of the Detroit Branch of the Federal Reserve Bank of Chicago. This is the first of several posts that will convey student observations made in their online journals and blog posts. All the underlying material can be found at the W&L WordPress site for Economics 244. I've cut-and-pasted pieces, with prose to smooth the flow, but tried to maintain the voices of my students so am deliberately leaving it a bit choppy.

This post combines material from Barrett Snyder, Michael Adams, Elizabeth Platt, David Hochstadt, plus snippets and photos from others. Due to cutting and pasting, I've not attributed everything. Particular thanks are due Barrett Snyder, who set up our visit.

Class began the morning of Thursday, May 12th by traveling from our base at the Best Western Greenfield to Belleville, Michigan, about halfway to Ann Arbor. There we visited Fox Auto Parts, which has been in business since 1973. Here we met with Bill Fox, one of two brothers, who own both an automotive recycling facility and a self service “pick and pull” style yard. Mr. Fox explained to us the process of purchasing totaled vehicles from two main auction companies, Insurance Auto Auctions and Copart, and how cars are dismantled and parts are sold to body and mechanics shops. Mr. Fox stressed the importance of purchasing the correct number of vehicles and of the correct type in order to turn a profit in a business model with such slim margins and high overhead. Auctioned vehicles run between $1,000 and $10,000, depending on the model and the condition; the average acquisition price is about $1,800. Each day Mr. Fox checks out insurance auctions online and bids on several different cars electronically. If a vehicle is not from the 40+ acre IAA facility that is located adjacent to their property, then then have to pay shipping costs as well. The focus is on relatively new vehicles; the average car is less than 10 years old. After that demand falls off, both because there are fewer vehicles left on the road, and because fewer people are willing to pay the cost of installing a "new" engine in a car that age.

Elizabeth Platt added notes on the process. The first stop was where the cars are brought in and the major parts are removed to be sold. While software helps Mr. Fox estimate of what the car is worth, until they actually get the vehicle they cannot know exactly which parts are salvageable. We watched them go through some of that process, as they inventoried a newly arrived vehicle for what sections of it seemed to have no damage – which lights appeared good and so on. They we visited the area where a power train was being dissembled and checked for leaks and other signs that it might not be good. There was also a bay where everything had been stripped all the way down to the frame of a F-150. Anyway, each pulled part is categorized with a tag to be easily accessible to be sold in the future. But once they've assessed the extent of the damage to the car and categorize all the parts from the car which they can sell, they then leave most of them on and use a forklift to put it in their yard. Then if they get an inquiry, their computer will let them know if they have a car where that part is undamaged out in their yard. That's a lot easier than pulling, categorizing and storing parts that might never sell.

The software used to purchase vehicles is called “Bid Buddy” and helps to generate a maximum bid for a vehicle by using a formula that accounts for part sales, activity, and current inventory. We also discussed the cooperation between independently owned salvage facilities. The greatest example of this was the PRP trailer system that runs across a good portion of the nation, used to transport brokered parts between recycling facilities to fulfill each others needs and help say “yes” to the customer more and more often. The network is run jointly by 80-odd recyclers, ranging from the Snyder family business in Texas at the southern extreme, through the midwest and into the northeast. Depending on locus a recycler gets a truck twice a day that can transport a body panel from Texas (no salt on the roads so no rust!) to Fox to sell to one of their customers. Fox in turn has a copious supply of Fords, including F-150s, and they may be sending a transmission from Michigan to Texas.

Sam Wilson noted that this cooperation was not just at the institutional level but also at the individual level. Not only did the owner of this yard know the father of Barrett Snyder, a member of our class whose family has owned and operated its own Auto parts yard for a long time in Texas. Barrett’s father had actually helped this owner expand into a secondary line of revenue, a You-Pull-It yard. The YPI yard was set up with many rows of cars by the same manufacturer and individuals could pay two dollars to enter the lot, search the cars and pull off/out whatever pieces that they needed. They paid a discounted price at the end for whatever they wanted to take home. From what Barrett explained, this is really becoming the larger end of the market down in Texas. This market is mainly made up of individuals who have some auto background and either: 1) are rebuilding for fun and need specific pieces for as a weekend hobby, or 2) their car broke down and rather than spend lots of money to take it to a repair shop will come to the yard and get the piece they need to be able to get to work on Monday.

They also have to judge how long to keep a car in inventory, as it uses both working capital and physical space – they keep their lot, which holds a bit over 900 vehicles, relatively full. We were all impressed that despite the outward appearance of the business as dirty and labor-extensive, it relies on a lot of technology. In addition to using a packaged computer program to assess the value of a car before bidding, Fox uses algorithms to track how often customers request certain parts based on inquiries and customer feedback; their sales staff do a lot more than just answer the phone. This information allows Fox to be sure to have high demand parts in stock at all times. The owner stressed to us during our visit that Fox is not competing directly with other salvage yards but is instead competing against auto parts stores such as Advance and NAPA, and even the OEMs. (For example, OEConnection uses their database of repair parts as the foundation for software systems that they sell to OEMs such as Ford, to help their dealers sell parts to independent repair shops including the in-house ones run by cities and other "fleet" operators.) Anyway, these national chains of parts shops and new car dealerships are the big players, along with a few large, publicly traded companies like LKQ that Fox and Snyder fee offer you poor service and a poor product because they lack the family touch.

Henry Schwartz noted that the cars are placed outside for an average of six months during which time Fox sells every part off the car that they possibly can. They can pull wires (copper), catalytic converters and other items of value. The car will be crushed and sold for scrap steel. (The don't have a shredder – for that stage of the recycling process see this blog post on the Prof's visit to one in Japan.) After six months Fox will only scrap a car after they have broken even on it by selling parts to customers. As Mr. Fox pointed out, more that 80% of the overall vehicle that comes into a facility is recycled, making it the “greenest” portion of the auto industry. Many people don’t realize that the shops that do insurance repairs for the public often use recycled parts. After receiving their vehicle back, most would assume that the parts used were brand new. All the while, that fender or windshield wiper motor that was installed is now living its life again in a vehicle instead of residing in a land-fill.

Platt was fascinated by the YPI yard. That business model illustrates how a company can make profit on items that would otherwise be discarded. By cutting out the cost of labor, the part can be sold for less and also attracts consumers seem to truly enjoy the process of finding parts and fixing their own cars. What however are the legal liabilities of this process? The customer must sign a release form and pay an admission fee, and bring their own tools, but the potential for accidents is still there. The owner did not go into detail about this. Nate Frank, another student, wondered if the ROI wasn't a lot higher in the YPI yard, as the 900+ cars in their main yard (plus the warehouse and so on) represents $8-$10 million.

David Hochstadt noted that there has been a decline in mid-sized salvage companies, many of which have been bought by larger, publicly traded companies. The smaller, family operated firms are left to fend for themselves and face the dilemma of either expanding or risking going under. Fox currently purchases around 100 cars per month whereas a firm like Barrett’s family will buy closer to 200 per month. The business is very fixed cost driven, building structures around items and engaging in capex intensive purchases like construction equipment and warehouse space, in order to move things around and store parts. In order to continue operating an expand, Fox needs to make shrewd decisions in terms of the price they pay at auctions as this will increase their margins and allow them to hire more employees, purchase more vehicles and expand their operations. It was amazing to see how much of a car can be reused even after it has been in a wreck and deemed totaled by insurance companies: everything from transmissions and engines to things like wire harnesses (as they have the highest concentration of copper in a car) and steering columns. He asked about the future of the car industry and how it would affect salvage companies as the average model year has been getting younger. Will they be able to salvage things like rear-camera systems, safety-critical parts where they would find it hard to judge whether they are truly without damage? In the next couple decades, won't the biggest threat to salvage companies be the shift to autonomous cars, as this would lower the number of accidents, hurting both how they obtain cars – supply – and demand for parts?

Friday, August 5, 2016

Tesla Note: Dealerships and Inventories

Mike Smitka

One point in my critique of Tesla's flawed business strategy is that by engaging in direct sales it uses up precious cash. First, it does continue to burn through cash, though at a slower pace: cash from operations plus financing in 2016 Q2 came to -$160 million, up from -$480 million in Q1. However, this includes $150 million in deposits for Model 3, so on a recurring basis they went through -$310 million. This was offset by $2 billion in new money, but I would expect financial markets to prove reluctant to keep providing new money at this pace. So Tesla needs to conserve on cash. Yes, they receive cash from leasing, $143 million in the past quarter. This is normal for the industry, particularly for high-end vehicles. However they and not their banks likely bear the residual risk. So this could prove to be very expensive cash if lease-end resale prices are less than those built into the leases. Such unpleasant surprises are far from unknown in the industry. Oh, and Tesla has also run through their subsidies from the State of California, in the form of ZEV credits: last quarter they were $57 million, but this quarter they were negligible. They won't be able to count on this cash and the fat per-vehicle margin it has provided as they move towards the Model 3.

So how can they improve their cash position? In two words: franchised dealerships. Ford Motor Co. had Q1 revenue of $36.9 billion and inventories of $9.8 billion, or 27%. Averaged across a few quarters gives a level of 25%. How about Tesla, with their direct sales model? They have inventory of $1.6 billion on revenue of $1.3 billion, or 125% – 5x the level of Ford.

Can Tesla afford to expand their direct sales network? My answer remains no.

Tesla violates two prime rules of new ventures: preserve cash and preserve management time

To be fair, there is a devil's advocate position. The land and structures of a dealership hold value, where used by Tesla or someone else. In particular, Tesla could lease its stores from existing car dealerships, with the added benefit that they might be able to avoid creating stand-alone service bays. Banks could also provide floorplan, industry jargon for the financing of dealership inventory. These would lessen the drain on cash – but on net they would not generate cash. Back of the envelope calculations – very round numbers – suggest that the cost of a national dealer network would run $5 billion. (I've gone back and forth on this with co-blogger David Ruggles and one other invidiual.) Net of financing, this might require $1 billion in additional cash, spread out across multiple quarters. So it is not out of the question. To my knowledge, however, Tesla has not demonstrated any distinct advantages to its direct sales approach, other than PR, at the expense of significant management time and (I suspect) legal and lobbying costs. In fact, on the Pied Piper dealership satisfaction index, which uses mystery shoppers, Tesla ranks dead last.

On the dealership issue Tesla violates two prime rules of new ventures: preserve cash and preserve management time. So I remain a skeptic.

Footnote: Nikkei just reported that Nissan – joint with Renault a larger electric vehicle manufacturer than Tesla – is selling off its battery making operation. Why? Doing it in-house is more expensive and slower in keeping up with new developments. Why should Tesla be an exception? Source: 日産、車向け電池事業撤退 子会社売却へ 2016/8/5 17:34 日本経済新聞 電子版

Saturday, July 30, 2016

Predicting SAAR, Deconstructing SAAR

Mike Smitka

As an economist, I avoid the prediction game. I am also wary of reading much into a single month's data. What an economist can do is to provide reasoning why over time a particular average level of sales makes sense, and levels significantly above/below do not.

Let me start with the monthly time horizon. Next Tuesday we'll get the latest sales numbers this coming Tuesday (August 2, 2016). Those numbers will tell use sales down to the last vehicle, except for Tesla, which reported sales of 2,250 for the past 4 months. That's a false level of precision. First, there's human error, though that ought to average out. A sale won't get reported, or digits will get reversed, or ... The Law of Large Numbers though means that while there will be over- and under-reporting by individual dealerships (and DMVs), those will average out and not cause much error in the total for the whole market. But one thing we know is that claiming there were exactly 1,513,086 light vehicles sold in the US in June 2016 is not true. When I present data, I try to round things off to 3 significant digits, here to 1,510,000 units.

I dutifully look at the numbers, but for the next year or so I really don't expect to learn anything from them

Then's there's the conceptual issue, that what "sold" means is less than clear. Dealers face incentives to tweak the numbers to earn "stair-step" incentives where one more vehicle can add a lot to their bottom line. Better to get the bird that's almost in hand by reporting a sale, than to carry it over to the next month when they might fall well short of (or significantly exceed) the threshold with an uncertain payoff. In Europe, discounting takes an indirect form: rather than placing cash on the dash, as it were, a car will be sold and reappear on the dealer's lot as a used car with zero mileage. They're "sold" and they're not. The data again offer a false sense of precision. Again, my sense is that an error (accidental or deliberate) in one month gets averaged out in subsequent months. But it does mean reading too much into one month is inappropriate.

Then there are the random factors, snow storms and holidays that fall midweek and ... there are such every month. Whatever the "true" level of demand, the performance in any reference period will deviate from that. Yes, we can apply seasonal corrections, and try to remember that February sales in a leap year will of course be higher, and sales in a month with 5 Saturdays may also be quite different. Such corrections however are but fancy averages, and so will never get the adjustment quite right.

So what can an economist say? There are the house economists at Ford and the others, who in conjunction with others in management need to provide a number for each product for the coming month and quarter and year for scheduling overtime and shutdowns at the plant level, for issuing purchase orders to suppliers orders for the next 30 days, and for planning capacity. In this role a house economist is as much soothsayer as professional. Formal models get combined with experience to which hunches are added, because at the end of the day there has to be a number. What will the Fed do? Over the past year, much less than the Federal Open Market Committee members themselves had predicted. But even if they bump short-term interest rates by another 25 basis points, will that affect the rates on car loans at all, or otherwise change sales? There's no reason to think they'll get this right any better than the traders who are betting billions on bonds.

why no mention of GDP: some "advanced estimate" components are good, the headline number not

An economist can however put some limits on what is likely to happen, using theory and a reading of the available data (which only show what happened last month or last quarter, never what is happening today, and absent theory tell us nothing useful about what will happen tomorrow). Here I look at two factors that influence automotive sales, interest rates and employment.

Employment first. Over the long run light vehicle sales correlate very closely with total employment, with about 1 sale for every .12 sales for every million workers, With 145 million people employed, that gives a SAAR of 17.4 million. This is not a tight relationship in the short run, and over the full period of the graph shows a downtrend. Indeed, a simple linear regression would suggest that I use .10, though for technical reasons that surely exaggerates the trend. In any case, that hints that 17.4 million is somewhat generous.

Employment continues to increase. Part of that is because the overall population continues to rise. Using age-specific population projections and the relatively stable rates of labor force participation prior to the Great Recession lets me estimate a normal level of employment, the red curve in the graph below. That's rising at about 58,000 a month in mid-2016, falling to about 50,000 by mid-2017 and 26,000 in 2018. In short, fertility plus immigration is barely offsetting the retirement of the Baby Boomers. On that basis the labor force will increase by only 900,000 workers over the next 2 years. That means we won't see SAAR rise by more than 100,000 units, which is smaller than the month-to-month volatility in the sales data.

But as we know, the US economy has yet to fully recover from our Great Recession. Compared against the demographic-corrected trend level, employment remains about 4.3 million below the pre-recession levels. The US economy has shown steady employment growth for the past 5 years, since summer 2011. We've also seen participation rates increase for prime-age workers, though that too remains below pre-recession levels. Barring a distinct slowdown or a boom – nothing in the real estate and residential construction markets suggests either – then we will keep adding jobs for another 2 years. Using the 0.12 figure, that will push car sales up by 0.5 million units. So if I were an optimistic, I could point to a potential SAAR of 17.5 + 0.1 + 0.5 or 18.1 million units by end-2018. I think the likely sustainable sales rate relative to employment is likely closer to 0.11, while the economy faces more headwinds than tailwinds...

How about interest rates? Here the picture is quite clear: they will stay low. First, the Fed is unlikely to raise rates aggressively, given the lack of signs of either inflation or accelerating growth. Second, across the globe growth are down. The developed world, plus China, are aging. The population of Japan is falling in absolute terms, and the working age population is falling in Europe and in China. Then there's productivity: an economy grows even with a fixed number of workers as long as output per worker grows. While we have new gadgets galore, the increase in productivity from having a smart phone is less than that from having a phone. We in the developed world see some gains, but the realignment of work that access anywhen to the cloud enables is only affects a certain share of jobs, is happening only gradually, and is not leading to large gains in output. That example can be repeated for a variety of technologies; see Robert Gordon's The Rise and Fall of American Growth for a systematic analysis. [The work structure example is my own.]

All of this is reflected in interest rates: they have fallen across all maturities, as reflected in bond prices. Furthermore, the yield curve suggests no upturn in interest rates for the foreseeable future (which for US bonds is 30 years), either due to stronger growth or to inflation (or, more accurately, the sum of the two). That strikes me as an odd bet to make at 20 year time horizon, and historically long-term bonds haven't been good indicators of what will happen. In the 3-5 year time horizon, however, the story told by bonds is more credible: we won't see a boom. I have both a basic interest rate graph, and one that looks at the implied yield on 1-year bonds, calculated for example from the difference in 2- and 3-year bond yields.

The final element is energy prices. My track record is abysmal, but so to my knowledge is that of everyone else. (For my posts on energy, See "Another Fracking Saudi Conspiracy Story" and here for "Peak Oil Revisited: Did I Get Anything Right?") From the perspective of extraction costs, the era of really cheap oil is over. For now, however, fracking offers a lot of potential at intermediate prices, while demand growth has slowed and the cost of alternative energy sources has fallen, including both solar and wind. The world has more natural gas than it can consume, and while over time the ability to transport it from where it is produced to where it might be consumed via pipeline and LNG ships will affect that, it's hard to see what might affect prices of gasoline in the US through 2018.

In conclusion, next week we'll see many column inches and blog posts dissecting the latest sales report. At the firm and maybe even segment level, it could contain information, though at the monthly level I'm still reluctant to play that interpretation game. More generally, we'll have more of the same. I dutifully look at the numbers, but for the next year or so I really don't expect to learn anything from them.

Thanks to Dr. Paul Traub of the Federal Reserve Bank of Chicago, Detroit Branch and former head economist of Chrysler for pointing out the strong correlation between employment and sales. This idea can be tweaked in various ways, setting up a multiple regression framework that would incorporate changing vehicle longevity, putting in a separate variable for those employed but over age 65 and for under 25, putting in a variable for changes in gasoline prices, and for the interest rate (or perhaps, using a combination of loan rates and loan maturities and vehicle prices, monthly payments). Obviously I've not done that.