Ruggles – AFN – Dec 2013
The price of new vehicles has been rising at a steady rate despite record auto manufacturer profits. This has been accomplished by just raising the price, through added content to base vehicles, and reduced expenditure on incentives. What is driving this trend? I see no evidence of any real movement in manufacturing costs. Labor costs via the D3 UAW contract are locked in for the next few years. What’s the deal?
Many believe the industry is preparing for the inevitable interest rate rise which will most certainly begin as early as next spring. Providing we get through the next round of debt ceiling issues in Congress in one piece and the economy remains resilient, new Federal Reserve Chairman Janet Yellen and her Board of Governors will need to begin backing of the level of stimulus the Fed has poured into the economy. That means interest rates have to rise.
Our industry has been enjoying the longest span of low interest rates I’ve seen in over 40 years. Dealers are often in the position of being in a positive cash flow position on their floor plan account, receiving more from their OEM in floor plan subsidy than they pay out in interest to their floor plan lender. Many have been lulled into thinking this is the way it is supposed to be, and that it will continue. I don’t normally make predictions, but I can guarantee that this is NOT the case and it will NOT continue. Our industry needs to brace for more normal interest rates. I believe that is exactly what the OEMs are doing.
The higher MSRP prices mean OEMs are positioning themselves to be able to offer below market interest rate subventions in an attempt to maintain volume momentum in the face of the inevitable rate increases. While subventions will most certainly be offered through OEM captive finance arms, manufacturers might also need to offer enhanced incentives for those buyers the “captive” doesn’t want to finance, for either credit or advance reasons.
Regardless, the subventions will funnel more business to “captives” and away from independent banks and credit unions. We’ll also see continued growth in leasing through “captives” with significant money factor subventions. Independent lenders who lack OEM support need to prepare for the inevitable downturn in business.
Dealers need to prepare for a flattening out of vehicle sales traffic while consumers adjust to the new reality. Dealers also need to prepare for a rise in floor plan costs by watching their inventory levels more closely. This hasn’t been much of a problem given the recent balance between production and demand, but a flattening out of sales traffic could change that quickly.
The pre-owned side of the business will also be impacted. In particular, the Certified Pre-Owned business will see challenges. As real market interest rates increase, the payments on a Certified Pre-Owned vehicle will rise to where there won’t be enough difference between the subvented payment on a new vehicle and the non subvented payment on a CPO unit to warrant a consumer considering the CPO vehicle. OEMs who aren’t prepared to subvent on the CPO side of their business, and to offer residual based financing alternatives for consumers, could be in for a shock. As CPO sales slow and inventory backs up manufacturers could see a sudden decline in late model pre-owned values as dealers aren’t so eager to stock CPO inventory at the same level as they did in a market with the artificially low interest rates they have enjoyed for the last few years. Against this backdrop, there are hundreds of thousands of fresh lease returns scheduled to reenter the pre-owned market.
As ex Federal Reserve Chairman William McChesney Martin once famously said, “The job of the Federal Reserve is to take away the punch bowl just as the party gets going." This was in the context of raising interest rates just when the economy approaches peak activity after a recession. Given the long run of low interest rates and the dramatic increase in money supply through Federal Reserve Quantitative Easing, this axiom has never been more important.
The punchbowl is about to disappear and it’s time to prepare for it.
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