Inventory builds and subpriming of auto market show problems in US

Today’s commentary

2014 is a transition year for the United States because 2013 was the breakout year for growth. In the third and fourth quarters of 2013, US real GDP statistics showed annualized growth of 4.1 and 3.2% respectively. Official statistics also say that unemployment is at 6.6%, near the point where the Fed is to switch to a tightening bias. On the back of this growth, the Federal Reserve has begun tapering its large scale asset purchases. But underneath these numbers are points of weakness.

And the weaknesses are what make 2014 a transition year. It is not clear that growth is powering ahead. Just the opposite, I believe Q3 marked the peak in growth and that growth in the US will decline from here. For me, the two biggest points of weakness have been inventories and wage growth.

Now, the picture most analysts want to believe goes something like this. After 5 hard years of anemic growth and lacklustre job prospects, the US economy broke out in the second half of 2013 toward a recovery sustainable without Fed stimulus. Job growth is almost at a 200,000 jobs per month pace. Consumer sentiment and business confidence are rising. Bank credit conditions are loosening. Consumer credit is rising. As a result, GDP is growing at above 3%. With defaults at a cyclical low and businesses flush with cash, soon capital investment and wages will rise too, making 2014 even better than 2013. As a result, for the first time since the recovery began, the Fed did not ramp up its asset purchase programs. Rather it dialled them back, letting interest rates rise and the yield curve steepen, both signs of an improved economic outlook.

That’s the narrative. And the individual parts of it are true. The problem is that inventory builds point to excessive optimism about end demand in the face of a lack of wage growth. Two quarters is not enough to confirm a breakout, especially when a lot of the growth in 2013 has come from inventory building in anticipation of demand. For example, we saw a 3.4% annualized increase in GDP in Q2 and Q3 of 2010 and a 4.3% average increase in GDP in Q4 2011 and Q1 2012 before growth faded and the Fed turned back to QE. Moreover, as Stephen Roach recently noted, inventory builds accounted for 38% of the 2.6% increase in GDP for the first three quarters of 2013. 0.42% of last quarter’s growth also came from inventory building.

Inventory building and capital investment optimism is especially high in the auto industry, where subprime financing is a key part of the picture. Ford had profits of $7.2 bn on the back of this. And despite warning about earnings growth in December, the company is making serious capital investments in 2014 and 2015. The company also plans to hire another 11,000 employees in 2014.

The problem is inventories. All of the American auto makers have over 100 days cars on their lots. Other car companies had an average of 88 days inventories on US lots. The companies blamed the January weather for the uptick. Chrysler, for example had 79 days inventories before the winter weather. And so now the car companies are discounting to purge those inventories. But this narrative doesn’t hold together. Even before the January cold snap there were more cars on US lots than at any time since 2005, at 3.4 million cars and light-trucks, a full 76 days supply. And US carmakers had disappointing December sales to boot.

At the same time, we are seeing a ‘sub-priming’ of the auto market as consumers borrow more to finance their cars.

“Until recently, bond deals with the word ‘subprime’ attached to them were seen as radioactive: Almost no one wanted to get near them,” said Adrian Miller, director for fixed-income research at GMP Securities.

“But that has changed, particularly when it comes to subprime auto. Economic activity is accelerating and car sales are expected to remain solid. As a result, we are seeing more of these subprime deals coming through.”

Sales of the securities started to rebound late in 2012, but subprime auto sales increased rapidly last year. Offerings by the likes of Santander Drive Auto Receivables Trust and Hyundai Auto Receivables were largely oversubscribed, people familiar with the sales said.

This week, American Credit Acceptance offered nearly $205m in subprime securities, while strong investor demand led Santander Consumer USA to increase an initial offering of $1bn in securities to $1.5bn, bankers said.

Investor appetite has been reflected in increased financing options at dealerships across the US, which helped propel auto sales to 3.7m units in the fourth quarter of 2013, the best fourth-quarter result since 2007, according to Bloomberg data.

[…]

Subprime auto sales accounted for 24 per cent of all auto ABS issuance last year, up from 20 per cent in 2012. 

Origination of subprime loans hit the highest levels since the financial crisis. Q2 2013 volume was $40.3 billion, up from the low of $14.9 billion in late 2009. That’s the most since Q2 2007, when the housing bubble was still a big factor. And note that race is a factor here just as it was in housing. According to a recent report, Latino and Black car buyers pay higher rates on loans even after controlling for other factors like credit score or income.

In terms of financing, despite increased longevity of vehicles, Americans are trading in their existing vehicles and tacking the previous financing balance onto new auto loans. And this is happening in a market for a notoriously depreciating asset. The average loan on a new car was to $26,719 at last check. The average loan-to-value on new cars was 110.6%. And on used cars it was a gargantuan 133.2%. Delinquency rates are declining but average loss rates are increasing on bad loans, now at $7,7770, which is almost one-third of the average loan on a new vehicle. Basically, car companies are using the originate to distribute model that blew up in housing in 2007, but this time with cars. Demand for cars is buoyed artificially by looser credit in the originate to distribute market. And the auto makers are sub-priming the market, preying on buyers by putting them into higher rate loans worth more than the price of the vehicle. If you are looking at auto asset-backed securities, you have to think this is a disaster waiting to happen.

Against a backdrop of weak jobs numbers in the last two months and weak wage growth, it is not at all clear whether the US is moving to new highs. It looks to me like households are increasing debt but that the basic outlook is middling. Inventories are building in excess of what is happening in the real economy. And that makes 2014 a transition year for sure.

To be continued.