Harvey to clear the industry's excess inventory

Mike Smitka

...the Thu 31 Aug Automotive News morning 'cast gives 300K-500K vehicles, but unfortunately the storm lingers...I hope I am wrong on the 1 million figure...

Harvey will cost insurers billions. Part of that will go towards the purchase of replacement vehicles. Macabre, yes, but that's a timely bump for an industry that has been grappling with excess inventory. Houston proper has 2 million people, and extend out to Harris County and you have almost 4.6 million. Immediately adjacent counties add 1.2 million more. At present the cars of a significant slice of that population are underwater, and will remain so for another day or more. That means they're totaled. Across Texas as a whole that certainly means 1.0 million vehicles, and perhaps more. A week ago the industry was awash with excess industry. Now it's not.

...for the auto industry Harvey is not a disaster but a turn of good fortune...

As sales fell over the past 9 months, the US industry built up inventory. A healthy level is around 60 days of sales. But by June 2017 dealers had 74 days worth of cars and light trucks on their lots, and pared that level only modestly to [Ward's] 69 days in July, or 4.2 million units. Of course this hides significant variation, with GM holding 104 days (0.98 million units) and Ford 76, while Subaru had only 40. Now much of the excess is in sedans, as demand shifted towards light trucks – the latter sold at a 10.8 million unit rate in June, while sedans sold at only a 5.8 million rate. The industry is responding: over the past year, NAFTA light truck production was [Ward's] up 4%, sedan production down 11%. That won't be reversed in the short run – suppliers can't spew out extra parts overnight – so sedan inventories were already set to keep falling.

Now Texas is truck country, as CNN's videos of Houston neighborhoods indicate. So Harvey won't be as big a boon for sedan sales, though Texans who find they're underwater on their loans may be forced to downsize to a mere car. The impact remains: 1.0 million units represents 16 days sales, and will help the industry draw down inventories to closer to 50 days. For the auto industry Harvey is thus not a disaster, but a turn of good fortune.

The US Bureau of the Census tracks the dollar value of automotive retail inventories. The most recent data – $68 billion in June 2017 – do not separate detail new versus used vehicles, or parts and tires versus vehicles. In contrast, the biggest purely retail sector, drugs and druggist sundries, comes to only $60 billion.

Auto Inventory Cycle Adjustment: More Pain Ahead

Mike Smitka
Washington and Lee University

During the extended housing boom of the early 2000s, consumers used home equity lines to go on a consumption binge. Light vehicle sales remained strong, while the model mix richened. Then the housing bubble reached its peak (and gas prices rose). The good times were over, and at the February 2009 trough sales fell to that of the trough of the 1981 recession. In relative terms the situation was far worse, because in the interim the US population grew by almost 80 million. Relative to employment, sales were a full 15% below the previous post-1976 (before which consistent data are unavailable).

Cars are durable goods, and even though the average vehicle now lasts 12 years, they eventually need to be replaced. Meanwhile the US population continues to increase and incomes have recovered (though for most Americans, not risen). From an excess of vehicles per household going into the recession, the number fell below what households wanted, and has now recovered. In February 2007 SAAR was 16.7 million units; that level wasn't hit again until March 2014. Fueled by low interest rates, longer loan maturities, and high used vehicle prices, sales crept back up. Indeed, Paul Traub of the Federal Reserve Bank of Chicago argues that they have been higher than sustainable.

...it's payback time...

It's payback time. Over the past several months the Light Vehicle SAAR (seasonally adjusted annual rate of sales) fell 7.5% from its December 2016 peak of 18.051 million units. This represents a drop of over 1 million units. Now  inventories rise and fall as a normal response to short-term swings in sales. With a steady fall, though, they mushroom, and mushroom they have. (Thanks to Paul and his May 2017 presentation to my W&L auto seminar for the graph on the left.) Now that the drop appears to be more than a transitory blip, it's time to bring inventories under control and pare production.

The supply chain is like a snake....

The supply chain is like a snake. If it's to eat bigger prey, it has to bulk up, and that takes time as suppliers rehire and otherwise add capacity. (This is on top of the normal investment to replace tooling for old models with that for new. Given the hit balance sheets took from the Great Recession, they also had to repair balance sheets to add capacity.) Going into the recession, production peaked in June 2007. It took over 6 years, until November 2013, to reach the previous peak.

....that's consumed too big a meal.

Now it’s like a snake that’s just consumed too big a meal: it's sluggish, because it takes time to get it out of its system. The Production Index hit 131 in October 2016, and bounced around that level through April 2017. It’s since fallen 7.6%. But that at best brings production in line with sales. It doesn’t pare inventories. That will require either an uptick in sales (fueled by assorted incentives) or a further cut in output. GM for example has chosen the latter, with extended summer vacations – not that they aren’t discounting, after all they can’t totally ignore price cuts by competitors. Output will surely fall more; it’s better to overshoot a bit, given uncertainly about whether sales will fall further. And today labor is no longer a fixed cost. As per Econ 101, the flip side of higher marginal costs makes it relatively more profitable to cut production than prices.

That leaves two questions. One: what is the stable level of output? I’ll save that for another post; too many graphs already! The second is employment. Here the bottom line is clear: productivity continues to rise, a trend visible as far back as data are available. Industry employment is certain to fall, and on a permanent basis. As a dismal scientist, I close with that graph, and with that of auto industry manufacturing employment.

I leave out many pieces. One is that while manufacturing productivity increased, that's much less true of automotive retail: employment there is at a historic peak. Then there are the finance, household formation, population data, household formation, depreciation and other pieces of the peak sales story that Paul Traub sets forth. I have not tried to put together the last couple months of inventory data, or compiled the various media reports of reduced production at GM factories, eg Lake Orion where the slow-selling compact Sonic (and the Chevy Bolt EV) are produced. Finally, while I can't provide any details, I do participate when my schedule permits in the monthly sales analysis roundtable that BWG hosts for their clients. My reading of these various sources is that at a more detailed level, some manufacturers are slower in responding than others, while the impact of the sales slowdown is uneven across manufacturers/brands, with for example the shift towards light trucks amplifying the impact on producers that are sedan-heavy, such as some of the Asian brands.

Real Yield Curve

Mike Smitka

I look at data of various sorts, often out of mere curiosity. One ongoing puzzle is the evolution of interest rates. I've posted graphs of nominal rates, and implied future rates. Below are similar graphs for real rates, as calculated by Treasury using inflation-adjusted bond (TIPS) yields. The first are the real rates at various maturities. (That's the graph on the left – click to expand.) I then use the difference between yields at different maturities to calculate the implied future interest rate. (Duh, that's the graph on the right.)

At one level these look sensible. We see that longer maturities have higher yields. We see craziness in fall 2008. But real rates remain low, around 1% into the far future. They look sensible, but they don't make sense.

...[they] look sensible, but they don't make sense...

One explanation might be global excess savings, what Ben Bernanke termed in 2005 as a global savings glut, driven by countries where individuals and firms are building up financial assets as their populations grow but where they've run out of sensible domestic investment possibilities. That requires financial outflows (and for that to happen, a trade surplus). And on the US end we do indeed see the flip side of trade deficits and net financial inflows. (Again, you can't have one without the other.)

After all, conceptually the return on investment ought to be higher in labor-abundant, poor economies. But I find it hard to believe that story, when we find it going on year after year. OK, many economies have unstable politics, which might make would-be investors cautious. So savings could pile up. But we don't see sharp breaks that might be consistent with that story, that is, with the ebb and flow of politics. Indeed, if that sort of uncertainty is key, we ought to see a huge Trump bump, because politics in the US now looks zany. Policy change is precluded by political infighting and the failure to appoint staff across the Federal government. We have no ability to address a crisis, much less attend to long-run challenges such as putting in place a true healthcare system, improving eduction or setting our fiscal house in order. The bottom line is that I don't see any such effect in the data.

The other story is secular stagnation: that despite the hype and self-promotion of Silicon Valley and the venture capital vultures who circle in search of easy feeds, there just isn't much happening. Cheaper taxi services – Uber, for example – just aren't working out. And from an economy-wide perspective it's hard to see an economic revolution in that, or better dating apps, or in receiving streams of 140 characters. In the $20 trillion dollar US economy, there's room for a lot of successful new $50 million businesses, but again, from a $20 trillion dollar perspective they are chump change. Robots? – I've been visiting factories for decades, automation is already widespread. The low-hanging fruit has been picked, and "hard" goods are only a 20% slice of our consumption. Artificial intelligence? The Executive Director of our small local United Way of Rockbridge worked in the earliest AI initiative at Stanford in the 1970s. Algorithms aren't new, and the cost of computing has long been near zero. Again, the low-hanging fruit has already been picked.

...the other story is secular stagnation...

My preferred explanation then is that (to borrow the title of Marc Levinson's most recent book), the transport, information and energy revolutions that exploded after 1800 represented An Extraordinary Time. That era has now come to a close, and henceforth we will no longer see the productivity growth that underlay the rise of the US. To borrow again, this time from Robert Gordon, this represents the Rise and Fall of American Growth.

However it's not just an American story, something emphasized more by Levinson than by Gordon. It's the story throughout the OECD economies, Europe and Japan and now even China. We can pray that in the next 3 decades South Asia and Africa converge on the developed economies through their own growth miracles. But for now they're too small, and too isolated financially, to offer a solution to the secular stagnation that we see in the US.

Disclosure: I'm using Levinson's book this fall in my 2 sections of Econ 102, Principles of Macroeconomics. I listened to the Audible recorded book version this spring, and am now reading the hard copy one. Gordon is also available as a recorded book, but given his prolific use of data, I can't imagine consuming it without his graphs in front of me – and I do my listening while driving.
For completeness, Bernanke reviewed his original savings glut story 10 years later, in a 2015 Brookings post. Here too is The Demise of U.S. Economic Growth, a modest-length paper that covers the stagnation themes that appear in the latter 100 or so pages of Gordon's 750+ page book.

Auto margins and disruption

Just a quick cross-reference in line with the previous post a great quote:

“TSLA, for all Musk's gift-wrapping abilities, is primarily a manufacturer, and history has shown us that the economics of the automotive industry are crap. ”

Graham Osborn, Contributor 10 Aug 2017, 09:51 AM

found in the comments to "Some Thoughts About Tesla's Latest Bond Offering" posted by Montana Skeptic at Seeking Alpha on August 10th.

No margins, no disruption: the New Mobility Challenge

Mike Smitka
Washington and Lee University

If you want to disrupt an industry, you need to pick one with fat margins. That's the real challenge for the entire family of "new mobility" models, and more generally for "disruptive" technologies in the automotive footprint. It's one thing to be able to arbitrage regulated monopolies, which is what most incumbent cab companies are. But that only works if your strategy provides you with entry barriers, and the monopolies you break into earn piles of money. Local cab companies are however perfectly capable of developing their own cell phone apps, benefitting from the high ratio of "locals" in the customer base. That's true up and down the automotive value chain: all operate with thin margins. They are thus NOT ripe for "disruption."

...why would anyone want to try to disrupt a market with thin margins?...

At base, motor vehicle manufacturing, distribution, repair, and the final market of transportation services have few monopolies. Yes, if you want to develop the next-generation diesel engine there are only two players who are capable of the underlying material science and have the ability to manufacture with the requisite quality in the requisite volumes. (These two are Federal Mogul and Mahle.) There are however multiple firms capable of "mature" piston production. The same is true for every other component that I can think of: there are often a small handful of "leading" firms but there are also commodity producers of older technologies. The only way to preserve margins is to keep innovating.

Furthermore, it's a complex chain. Assembling vehicles, as Tesla is learning, is the easiest part – and they don't yet have their Model 3 assembly line up and running, despite having more employees than the normal volume assembly plant. But that's the tip of the iceberg: they have yet to solve the national distribution challenge in a cost-effective manner. Assuring that component supply lines can meet your production plan, and that you can take tradeins, provide financing and repair vehicles quickly, all that takes a lot of people and a lot of physical assets. Experience helps, too. If you're to grow rapidly, those have to be in place beforehand. Some resources can be borrowed, including the financing, as happens in the "traditional" franchised dealership system (though Tesla has decided not to do so).

It took over a decade from their establishment of a solid footprint for Honda, Toyota and VW to succeed – and as VW has demonstrated, laurels can be lost. After all, in the early 1960s and again around 1968 VW was THE import market in the US. They're now barely a player. The VW vertically integrated, single model mass production strategy worked for a while, as did Henry Ford's monomaniacal focus on the Model T and nothing but the Model T. Neither VW nor Ford were ever able to lower costs sufficiently to develop a sustainable advantage against the evolving products of rivals. In contrast, Tesla is a high-cost producer with a high-cost distribution system. High costs aren't an insuperable barrier if you aim to break into the premium car segment, but even then you have to keep renewing your product. High costs don't work if you aim for the high volume, middle-segment of the market.

Ditto Uber on the downstream transportation service end: taking over the taxi business would be great, but only if the underlying business was unusually profitable. But it's not. There's little room for cost reduction – materials, labor, overhead. It's not as though existing taxis are new and drivers well-paid. There not much room to cut economic costs, even if in the short run costs can be shifted to unsuspecting parties (Uber's owner/driver contractors). The only way Uber can provide reliably better service than incumbent Yellow Cabs is to have higher peak load capacity, with the requisite assets of vehicles and drivers. Superior service at a comparable price lets them grab market share, but they've not expanded the market. And without a bigger market they can't sustain their high-cost strategy. A cell phone app doesn't lower the cost of a car, or lower the minimum wage paid by alternate jobs. To reiterate: creating a big taxi company does not provide a route to healthy long-run margins.

...creating a big taxi company does not provide a route to healthy long-run margins...

So don't be fooled by the apparent ease of entry by disruptors. Yes, Tesla can draw upon the base of automotive suppliers to launch a car, something that would not have been possible in the more vertically integrated world of the 1960s. Numerous Chinese domestic players have done the same, and one or two may even survive if not thrive, the Geely's and Great Walls. But Tesla can't rapidly expand in the mature markets of NAFTA and the EU, absent a revolution in battery costs that decades of leading-edge chemistry research has yet to deliver. They can't compete in costs against the still-improving technology of the internal combustion engine. They can't compete by eroding the fat margins of incumbents, because margins aren't fat.

Autonomy is much the same. The suite of sensors need to be integrated into a vehicle, software integrated into the actuation of steering, braking and so on. Everything then needs to be tested. Car companies are good at that – that's why they're called assemblers. Many of the pieces are already in place, but consumer acceptance is still uncertain, and the only way average transaction price can rise is if sales fall: the average new car purchaser can only finance so much, given stagnant incomes amidst a driving population that is virtually flat. In other words, implementing a costly technology won't help margins. Indeed, it's already gotten the CEO of Ford fired.

...govt policy can disrupt the (auto) market, but not Tesla, not Uber, not Waymo...

There is one exception: government policy can disrupt the market, by enacting direct and indirect subsidies (such as California ZEV credits or safety mandates). But not Tesla, not Uber, and not Waymo. What is amazing is that, given automotive margins, they purport to have "disruption" as their strategy. It may work on the stock market, at least for a while. It won't work in the automotive market.