Wall Street’s post-election rally suggests that many investors currently have the wrong idea about Donald Trump. They have decided he is a new Ronald Reagan, with policies that will deliver a major bull market.
But those promoting this narrative have forgotten their history. Both men certainly share a link with the entertainment industry. But Reagan took office towards the end of one of the worst recessions in the 20th century. By contrast, Trump takes office at the end of an 8-year bull market.
Prof Robert Shiller’s CAPE Index (based on average inflation-adjusted earnings for the past 10 years), provides the best long-term view of the US stock market, going back over a century to 1881. As the chart shows:
Ronald Reagan took office in January 1980, when the CAPE Index was 9.4
It fell to 6.6 in July/August 1981 at the bottom of the recession, when the S&P 500 was just 109
At the end of Reagan’s Presidency it was still only at 14.7, and the S&P 500 was at just 277
Today, Donald Trump takes office with the CAPE ratio at 28.5 and the S&P at 2271, after an 8-year rally
Is it really credible as a Base Case that the rally could continue for another 8 years? After all, Trump himself claimed back in September that the US Federal Reserve was being “highly political” in refusing to raise interest rates:
“They’re keeping the rates down so that everything else doesn’t go down. We have a very false economy. At some point the rates are going to have to change. The only thing that is strong is the artificial stock market.”
Common sense would also tell us that Trump is about to make sweeping changes in economic and trade policy. He made his position very clear in October with his Gettysburg speech. And his Inauguration Speech on Friday explicitly broke with the key thrust of post-War American foreign policy:
“We assembled here today are issuing a new decree to be heard in every city in every foreign capital and in every hall of power. From this day forward, a new vision will govern our land. From this day forward, it’s going to be only America first, America first. Every decision on trade, on taxes, on immigration, on foreign affairs will be made to benefit American workers and American families.”
Change on this scale is never easy to achieve, and usually starts by creating major disruption. The expected benefits take much longer to appear. This, of course, is why “business as usual” is such a popular strategy. But it is clear that Trump is perfectly prepared to take this risk. As he said at the start of the speech:
“We will face challenges. We will confront hardships. But we will get the job done.”
Many companies and investors are still hoping nothing will change. But CEOs such as Andrew Liveris at Dow Chemical and Mark Fields at Ford have already realised we are entering a New Normal world:
Liveris told a Trump rally last month that jobs would be “repatriated” from outside the USA when Dow’s new R&D centre opened, adding as the Wall Street Journal reported “This decision is because of this man and these policies,” Mr. Liveris said from the stage of the 6,000-seat Deltaplex Arena here, adding, “I tingle with pride listening to you.”
Fields personally told Trump of their decision to cancel the Mexican plant and invest in Michigan, saying “Our view is that we see a more positive U.S. manufacturing business environment under President-elect Trump and the pro-growth policies and proposals that he’s talking about”.
The reversal of US trade policies will impact companies all around the world. The White House website has already confirmed the planned withdrawal from the TransPacific Partnership – and from NAFTA, if Mexico and Canada refuse to negotiate a new deal. China is certain to be targeted as well. Protectionism will start to replace globalisation.
This means that today’s global supply chains are set for major disruption. This will directly impact anyone currently selling to the US, and US companies currently selling overseas. It will also impact every supply chain that involves a final sale either to or from the US. The Great Reckoning for the policy failures since 2009 is now well underway:
The Dow Jones Industrial Average’s repeated failure to break the 20,000 level may well be a warning sign
Japan’s Nikkei Index was also poised to hit 40,000 when closing at 38,916 on 29 December 1989 – but never did
Sometimes, as US writer Mark Twain noted, “History doesn’t repeat itself, but it often rhymes”.
The warnings keep coming about the underlying health of the US auto market. But, as with the subprime housing crisis, nobody wants to listen:
- Last October, the US Comptroller of the Currency warned that some activity “in auto loans reminds me of what happened in mortgage-backed securities in the run-up to the crisis“
- Yet auto lending is now more than 10% of total retail lending, and the banks are still busy repackaging them for sale as securities to investors desperate for yield
There are 2 parts to the story, as the charts above show, both from the Wall Street Journal (WSJ):
- Auto leasing is now at record levels at 1/3rd of total car loans, compared to pre-crisis levels of one in five
- Manufacturers subsidise these deals to make them attractive – currently by an average of $6432
- These lease incentives have been rising sharply, and are up 8% versus 2015 and 29% versus 2009
- Auto loans are also now at record levels, close to $1tn, with 20% going to subprime borrowers
- Issuance of bonds backed by subprime loans is up 25% from 2014, and these are already going sour
- 12% of loans in bonds only issued in November were already overdue by February
Of course, everyone insists that the Comptroller is wrong to be worried, just as they said the housing market was in great shape – until it collapsed. But warning signs are everywhere, if one wants to look. Delinquency rates on subprime loans packaged over the past 5 years are already over 5% – and that is with an improving jobs market.
The problem is that loans are being made to people with very low credit scores, or even no credit scores. And they are being asked to pay interest rates of around 20%. This is clearly unsustainable, and highlights how the auto industry is gradually running out of potential new customers – just as happened with housing.
At the same time, manufacturer inventories are rising, up to around 90 days for Ford and Fiat Chrysler, whilst overall incentives have risen to 10.6% of revenue. Ford’s car inventory is 38% above its normal level at this time of year, despite it having boosted lower-margin rental car deliveries (adding 7% to its total volume).
As Credit Suisse note, auto makers will soon have to cut production, as their current sales strategies are running out of road. They expect a 6% cutback from Q2, meaning that 2016 production would be flat versus 2015. But this may well prove too optimistic.
The reason is that nearly 9 out of 10 new cars are currently financed:
- Loans are typically 6 years, so even buyers from 2012 won’t return to the showroom till 2018
- Lease terms are typically 3 years, meaning 2016 will see large numbers low mileage cars in the used car market
Used cars are therefore going to have a very attractive value proposition for the ordinary buyer, as their average mileage is currently back to 2002 levels:
- 3.1m cars come off lease this year, a 20% increase versus 2015, followed by 3.6m in 2017 and 4m in 2018
- These used car sales will cannibalise new car sales, pushing down prices and volumes
- Price wars are therefore almost inevitable over the next 18 months, and lenders will start to lose serious money
The industry has been here twice before, as the WSJ notes – and both times the story ended very badly, with lending losses running into the billions of dollars:
“The auto industry expanded the use of leasing in the mid-1990s, helping to fuel retail sales of new vehicles. Eventually, a glut of off-lease cars sent resale values down and auto lenders who had bet residuals would remain high ended up racking up billions of dollars in losses, having to sell the cars for much less than they anticipated.
“Many major banks exited leasing the early 2000s, but the practice resumed later in the decade. Lenders saw another leasing crash late last decade when resale values plummeted amid a steep rise in gasoline prices and low demand.”
Of course, all those making short-term bonuses from selling the loans and leases, or repackaging them for sale to investors, naturally claim that everything is fine. But the rest of us know what to expect.
Past experience is normally a good guide to the future outlook.
Something strange is happening in the European auto market, as the above chart from the industry association shows:
- Normally there are seasonal patterns, with March seeing the highest sales of the year
- But the trend of increase or decline is normally fairly stable in either direction
- This year, however, both March and now June have shown bumper percentage increases
- March was up 10.6%, well above the rest of Q1: June was up 14.6%, again well above the rest of Q2
It seems unlikely that seasonal patterns have suddenly changed quite so much, especially as March has always been a strong month.
Instead, it seems more likely that dealers are self-registering new cars in order to meet quarterly sales targets from the manufacturers. Thus the Financial Times reports that in reality UK sales are actually flat or falling – even though 7% more cars were registered as sold in H1 2015 versus 2014. It note:
- “More than a quarter of registrations in June came on the last day of the month
- “As many as half the registrations were being recorded in the final four days of the month as dealers push to meet targets
- “(These are) so-called self-registrations, where dealers sell the cars to themselves to meet incentive targets from manufacturers. The cars are typically held for 90 days and then sold on as used vehicles.”
Estimates for UK self-registration suggest it now accounts for at least 11% of total UK sales, and higher percentages in other key markets such as Germany. And this is despite average discounts in Germany now reaching 20%.
Leading manufacturers, of course, know that this is simply putting a sticking-plaster on the problem. Ford, GM and BMW are all now pushing hard into the car-sharing market, even though they know this will reduce their overall sales:
- Opel (part of GM) will offer “car sharing for everyone” via a dedicated Opel app on its CarUnity programme
- From next year, BMW will allow Mini buyers to rent their car via its DriveNow network in London and in the US
- Ford are allowing 12k London customers to rent their cars via peer-to-peer platform easyCar Club
As GM’s president said last month about owning a car in a city:
“It’s the last thing you should do because you buy this asset, it depreciates fairly rapidly, you use it 3 per cent of the time, and you pay a vast amount of money to park it for the other 97 per cent of the time”.
Auto manufacturers, unlike car dealers, have alternatives when it comes to confronting the challenge of car-sharing. Smart ones will realise that increasing numbers of people are no longer interested in owning cars. And so instead, they will focus on developing new income streams based on the megatrend of mobility.
May was “another fantastic month for US auto sales”. Or, it took the industry “one month closer to an inevitable downturn”. All depends on which analyst you talk to:
- Ward’s Autos called May’s sales the best since July 2005
- LMC Automotive suggested growth rates were slowing, and could possibly even contract next year
It also depends on how many questions you ask.
The headline numbers are clearly good. And they are not being achieved by major discounting, which was the position last year. Then, average incentives had hit $2633 in February, and headed higher into the peak spring selling season.
But look a little deeper, and problems quickly emerge. Prices in the used car market have begun to fall, with those for some “near-new” compact vehicles down 2.8%, and midsize values also weakening. The reason is better availability, as buyers trade-in used cars for new leases.
The US Federal Reserve’s cheap credit policy has meant that 4 out of 5 auto sales are now bought with credit or leased. Effectively, therefore, it is helping to grow the “sharing economy”, where drivers no longer feel the need to actually own the vehicle they drive.
This has good and bad results. In the short-term, it means automakers can increase prices and margins, and still make sales as the cost is spread over a longer period. But in the medium-term, it means they must expect to see lower sales in future years. The reason is simply that lease terms have been rising to unheard-of levels.
The average US auto loan is now at 69.7 months, which means it will be 2021 before the buyer comes to the end of the loan period. And as the chart shows, these changes in the market are challenging the dominance of the “Big 4′ US manufacturers:
- Their combined share of the total market is now just 60%, well down from the 73% seen in Q2 2005
- GM’s share is down at 18% versus 32% then (blue); Ford has slipped to 15% from 18% (green)
- Toyota has recovered to 15% after its recalls (purple); FiatChrysler has slipped to 12% from 15% (red)
Volkswagen highlights the pressure they are under. With an ageing fleet line-up, it is now forced to offer its Jetta model on a lease costing just $39/month in San Jose California, or between $89 – $99/month more generally. You could end up paying more per month for some mobile phone packages.
And, of course, there is always car-sharing itself. Ford have now followed BMW and Mercedes in entering the market with its new Go!Drive brand. And each shared car takes 17 privately owned vehicles off the road, according to industry estimates.
Of course, many people will still want to drive their pick-up trucks and SUVs. But there are clearly an increasing number of people who are looking for new ways of meeting their need for mobility. As a result, it seems likely that the US auto market will look quite different in 5 and 10 years time.
We’ve all had that moment of jumping into the car, and turning on the ignition, only to realise we forgot to fill up the fuel tank on the last journey. US auto sales data for April is flashing that same familiar orange warning light.
From the outside, everything looked fine with the data. Although there were warning signs – such as annualised volume below expectations at 16.5m versus 16.9m, and sales growth depending on utility vehicles and pick-up trucks, rather than autos themselves.
But the real concern came in a report from analysts Edmunds.com on the continuing increase in loan terms to finance car purchases:
- These used to be a standard 36 months, leaving the owner free to buy a new car after 3 years
- April’s average was 67.8 months, the longest in history
- Many companies now even offer loans on 80 or 84 month terms to keep sales rolling
This is clear evidence of companies’ growing desperation to maintain their volume. Anyone offering 7-year loans is essentially cannibalising future sales. A buyer who is locked in for 84 months won’t be back in the dealership until 2022. Even the now standard 68-month loan keeps them away till 2021.
Whereas in the past, the buyer would have been back in 2018.
Even more worrying is that 1 in 4 auto loans are now to subprime borrowers. And many are not only for 7 years, but also in excess of the value of the car. As the Office of the Comptroller of the Currency warned at a conference earlier this year:
“Let that sink in. That means it is not uncommon today for a family with subprime credit to take a loan at 110 percent of a used car’s value that they will be paying off for seven years.”
It seems, however, that the use of these longer loans is critical to companies’ ability to sell the more profitable larger cars. Buyers have been trained to think in terms of monthly payments, and so trade up without realising the full cost.
The chart above suggests that the underlying weakness in US auto industry is also impacting housing:
- The red circle shows annualised sales in the first period of US Federal Reserve stimulus in 2000-2007 (after the dot-com crash), and the green circle shows the period since 2008 (after the sub-prime crash)
- The 2000-2007 period led to a major increase in both auto sales (horizontal axis) and housing starts (vertical), as lending standards fell – until, of course, the sub-prime collapse led to 2008′s financial crisis
- Then the period since 2008 has seen ultra-low interest rates combined with sub-prime lending standards
- Even so, sales in both key areas have clearly failed to recover to the 2000-2007 level
The only question now, of course, is how long this pattern of extending loan terms can continue? Could they go to 9 years, or even 10 years?
As with an empty fuel tank, we can only guess at how many miles we have left before the auto sales engine stops.
Major problems are developing in the US auto market. The critical issue is that companies have been adding capacity since 2009 on the basis that demand would return to SuperCycle levels. But it hasn’t.
The result is that the mass market has become more and more competitive. Only sales into the high margin luxury/pickup segments are actually making a respectable profit, as Bloomberg has noted:
“There is no vehicle type more important to the Detroit Three than pickups. They generate $8,000 to $10,000 in gross profits per vehicle and still produce most of their automotive income, according to Morgan Stanley.”
In turn, this means that financing deals have become critical to maintaining sales. Today, an astonishing 85% of new car sales and 54% of used car sales are being either financed or leased. As analysts Edmunds.com note:
“Buyers have been able to secure low financing deals and have responded to lease offers in record numbers.”
Yet despite these offers, as the chart shows, total sales in the year to September are only up 5% this year versus 2013. And as Ford’s chief economist warned:
“We are reaching a point where the rate of growth is beginning to moderate. We are getting closer to a likely plateau.”
The reason is that companies have already pushed the boundaries as far as possible. Loans to ‘deep subprime buyers’ (those with credit scores below 550), have been the main driver for recent sales growth, along with the increase in lending term. Deep subprime loans jumped 13% in Q2, up 770k, compared to 5% overall loan growth.
THE VOLUME MARKET IS OVER-SUPPLIED AND INTENSELY COMPETITIVE
The detail of the incentive programmes highlights the intensely competitive state of the market. Honda have increased their incentives by 41% since September 2013, Nissan by 26%, Toyota by 23%, Fiat-Chrysler by 16%. Only Hyundai has actually reduced spending.
At the same time, they have increasingly had to offer long-term loans to those buying the higher-priced cars on which they still make money. Otherwise, buyers couldn’t afford the monthly payment:
- One in 4 auto loans now has a payment term of between 6 to 7 years – the highest ever recorded
- The average monthly payment on these loans is a record $474/month
- The average lengthy of all auto loans is also at a new record of 5 1/2 years
Of course these strategies are self-defeating. By tying buyers in for 6 years, the companies essentially miss the chance to sell them a new car before then, as the existing loan is still being paid off.
PROBLEMS ARE GROWING IN THE SUBPRIME LOAN MARKET
Even worse, however, is the growing reliance on subprime loans. The New York Times reports shows these were 27% of all auto loans in 2013, with interest rates often at 23% or more. And total subprime lending in Q1 reached $145bn.
Of course, the automakers know that these borrowers are highly likely to default. So they are increasingly forcing these buyers to install ‘starter-interrupt devices’. These are now installed in around a quarter of cars bought with subprime loans. They allow lenders to disable the car remotely, leaving the driver unable to operate their car.
As one would expect, these are increasingly leading to horror stories of car engines being turned off when payment is late by a day or two. And even worse, the NYT reports claims that engines have been turned off whilst cars are being driven on the freeway. None of this sounds like an industry which is likely to see robust growth for the next few years.
Instead it gives the impression that companies are ’scraping the barrel’, trying to achieve sales by any legal mechanism in order to boost today’s revenue. As BusinessWeek reported last year:
“Perhaps more than any other factor, easing credit has been the key to the U.S. auto recovery,” Adam Jonas, a New York-based analyst with Morgan Stanley, wrote in a note to investors last month. The rise of subprime lending back to record levels, the lengthening of loan terms and increasing credit losses are some of factors that lead Jonas to say there are “serious warning signs” for automaker’s ability to maintain pricing discipline.”
A year later, we are clearly much nearer the end of this second subprime boom. As we learnt in 2008, companies cannot create a sustainable business model by lending at sky-high rates to people who cannot afford to repay the loan.