Is the Auto Market About to Go Kablooey?

There is no clearer way to say it - the debt market drives the auto market. After robust growth for years driven by easy credit warning signs are emerging.

In a research report today, Morgan Stanley's Adam Jonas asks "Is the greatest auto credit cycle finally over?" He highlighted 5 key thoughts on auto credit worth considering:

1. 90% of cars are bought on a monthly payment in the US. In addition to a recovery of US auto sales to all time highs of ~17.5mm units last year, the average transaction price of car sales in the US has increased by almost 30% since 2003 to ~$34,000 while at the same time, monthly payments have increased by ~10%.

2. Volume is the usually last thing to fall--it's a lagging indicator. Given the growth in capacity to produce, high starting points in margins/cash and large captive finance subs, OEMs tend to make many strong efforts to keep volume moving in an upward direction. A declining trend in US auto volumes would imply that the collective and repeated efforts by the manufacturers to keep volume moving or flat, mainly through price declines, did not work. The implication for industry profitability even in a flat volume environment could mean a substantial decline in earnings forecasts.

3. The CEO of the largest publicly traded auto dealer in the US just... rang a bell. Should we listen to what he is saying? During the Detroit Auto Show, Autonation (NYSE: AN) CEO Mike Jackson expressed concern over the sustainability of the US auto cycle and both consumer and manufacturer behavior, saying: “the fourth quarter industry sales environment was more push versus pull,” prompting him to warn of significant margin declines in both new and used volume. Mr. Jackson also expressed concern over production of vehicles outstripping ‘real demand.’ Mr. Jackson further added: “The auto industry is cyclical… and anyone who says it’s not is in denial.” We attended 2 industry conferences during the show and were surprised at how little management teams were asked about Autonation’s comments.

4. Watch the ABS market. The ABS market is the most nutrient-rich strain of phytoplankton in the credit market on which all higher organisms in the automotive ecosystem feed. We would point out a degree of self-reinforcing circularity in the relationship between new car prices, used car prices and the ABS market. Strong new car prices, helped in part by low monthly payments and cheap fuel prices, helps support the market for used car values, helping to support economic conditions in the ABS market. A strong ABS market in-turn helps financial institutions more confidently lend to consumers, helping to drive higher new prices, supporting higher used car values… you get the idea. The ABS market has been an important source of funding for many auto financing institutions. For example, at Ford Credit, securitized funding as a % of receivables ended the 3rd quarter at 39%. By the end of 2015, Term Asset-Backed Securities are expected to have accounted for approximately 40% of Ford Credit’s funding (See main exhibit).

5. What is the CDS market telling us? Since the beginning of 2016 (through Jan 20th), Hertz's (NYSE: HTZ) 5-year CDS has moved from around 335 to 637. Avis Budget'S (NYSE: CAR) 5-year CDS has moved from around 325 to 577. We’d highlight the importance of the securitized market for helping to reduce borrowing costs for not just car rental firms, but also for auto finance companies and leasing companies.

To wit: investors in the market may already be preparing for this with the stocks of auto-giants GM (NYSE: GM) and Ford (NYSE: F) both down 14% year-to-date despite strong fourth quarter and 2015 results.

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