The Upcoming Fiscal Cliff

By David Ruggles, originally published in Auto Finance News

The upcoming “fiscal cliff,” as it’s known in investment circles, is the proverbial “sword of Damocles” hanging over the head of the world economy. Somewhere, Grover Norquist is smiling, while the global economy hangs in the balance. When the country’s two political parties couldn’t agree on a deficit-reduction package ― which the Republicans held as hostage to approving an increase of the country’s debt ceiling a year ago, according to Senate Minority Leader Mitch McConnell ― the two parties entered into a sort of “death pact” known as sequestration. Both parties agreed to concessions previously deemed unpalatable to force them into an agreement before the end of 2012. The concessions have the potential to bring catastrophic impact to the U.S. economy and, hence, to the global economy.

The yearend date was selected because the November presidential election will have been decided, and Congress will be in lame-duck session. In theory, this should make it easier to reach an agreement, but only if the Republicans agree to some tax increases on upper-bracket earners. Under the sequestration agreement, draconian cuts will be imposed on defense and social programs, and the Bush tax cuts will expire, which would bring about tax increases on all taxpayers, not just the top bracket.

The threat of having all the above happen simultaneously has the business community running scared, and with good reason. The spending cuts alone amount to $1.2 trillion evenly split between defense and non-defense spending. The expiring Bush tax cuts will raise taxation at the exact same time federal government spending is cut. One doesn’t have to believe in Keynesian economics to see the potential for short term disaster if agreement isn’t reached on a better balanced plan so the shock of the scheduled tax increases and spending cuts does not occur at the same time.

As of this writing, all of the consternation has yet to spill over to the stock market, as the Dow continues to reach new heights, having restored around $23 trillion in wealth since the Obama stimulus package passed. Whether those two events are connected is anyone’s guess, but the fact remains that many Americans’ IRAs and 401Ks are in much better shape than they were in the fall of 2008. Almost $50 trillion in accumulated wealth evaporated in a short time between the dramatic reduction in household net worth and the tanking of the stock market when the financial crisis hit. Only about half of that has been restored through the stock market, as the housing sector is still shaky. This explains the weak recovery.

At the same time, the credit scores of many consumers have been maimed, preventing them from buying the type of large-ticket items that add manufacturing jobs. Perhaps the electorate will be convinced that a President Mitt Romney can restore the household net worth and quickly heal maimed credit scores while cutting taxes and the deficit. If the electorate is convinced that he can, we will have a new administration come January 2013.

Simultaneously raising taxes and slashing government spending could stop the recovery in its tracks and trigger another recession. As we get closer to year end, if an agreement is not reached early, an unlikely prospect at best, expect the Dow to retreat, car sales to fall off, unemployment to spike, and the ripple impact to affect the global economy while our politicians play brinksmanship with all of our lives.

There is incredible pent-up demand in our economy. The recent small drop in the unemployment rate and the addition of 114,000 jobs should be cause for optimism. To put this in perspective, the 114,000 jobs added in September marked a 900,000 job turnaround from January 2009. Economists say we should achieve around 350,000 additional jobs each month to be considered in robust recovery.

Fitch Ratings and others predict that should agreement not be reached, the result would be another recession.

So how long will it take to heal credit reports and restore household net worth through consumers paying down debt and home prices escalating? Will sequestration take place, taxes rise, and government spending be drastically reduced? Will politicians play with all of our well beings for the sake of partisan ideology? The uncertainty is just another thing holding back recovery.

David Ruggles has spent his career in every phase of the retail side of the auto business, new and used, sales and management, including consulting and training in both the U.S. & Japan. Ruggles has been a dealer for Mercedes-Benz, Chrysler, Dodge, GMC, Ford, Mazda, and Subaru, and has consulted for one of the world’s largest privately owned Toyota dealer groups located in Japan. He blogs at autosandeconomics.blogspot.com and writes regular columns for several publications.

Europe's Troubles: BMW postscript

...my quick analysis suggests no European OEM will weather the coming storm without taking on a fearful amount of water...

According to an August 16^th Bloomberg post on BMW, discounting is rampant in the German market, while sales are not responding. (According to a friend who has worked in Europe, this phenomenon of phantom sales goes back decades, rediscovered in each recession given that the careers of analysts and reporters of the industry seldom span multiple downturns.) Now I visited BMW's plant in Spartanburg, South Carolina in January 2012; it was running flat out and adding capacity, because the models produced there are global hits, with the majority of output exported. My back-of-the-envelope calculations suggest that plant is about 1/5^th of BMW's global output, given capacity additions in China.

Of course a big slice of those exports go to Europe, which is in recession; overall the region accounts for 30% of BMW's sales. The elimination of the "block exemption" in late 2003 removed restrictions that limited the ability of dealerships to sell cross-border; German stores now compete with those in Italy. As long as the euro lasts, troubles in one large market now spill over to the rest of Europe. [And if the euro doesn't last ... but that's my premise.] Meanwhile growth has slowed in the BRICs, which account for 25% of sales.

So while the European near-luxury makers are more diversified than Peugeot, Renault or Fiat, they too remain vulnerable.

And then there's the massive VW empire, 10 brands including a full range of trucks, and a solid sales base in most markets except the US and Japan -- and it is now targeting the US aggressively. However, with a market share of just over 4%, its footprint simply isn't large enough to generate sufficient profits to offset weaknesses elsewhere (and with a new plant, depreciation looms large, good for cashflow but not the bottom line). To analyze how the firm will weather the looming European meltdown would require piecing together these operations. Analysis is further hampered by the lack of geographic data in the stock analyst reports I've scanned. They may be the best immunized -- but I can't make a case one way or the other.

...Mike Smitka...

Addendum: Pending blog post I spent over an hour discussing the European industry with a retired senior Detroit 3 executive whose career included multiple postings to Europe. He helped point out variations across firms and markets, a level of detail beyond my experience or ability to quickly [this is a blog!] research. More once I hit a comfortable rhythm with my teaching overload this fall, and add nuance to my analysis of Europe.

How do you like your cone? – double-dip?

Part I

Where will growth come from, as the stimulus money runs out? – though the construction portion will keep being shoveled out for months to come. The dollar is weak against the Canadian dollar, the yen and the yuan, but not against the euro and has strengthened against the Mexican peso. So exports? – not likely. And exports simply aren't a big enough slice of our economy (about 10%) and are more sensitive to foreign incomes. Good for exports to China, but not otherwise. It keeps US imports low, too, but that's a reflection of bad news, not a source of good news.

What of the consumer? Unemployment remains high, and long-term unemployment is at record levels. Job losses remain high, so there's uncertainty. For the rich, who tend to save, capital gains and dividends and corporate bonuses remain low.

Investment still faces a housing and now a commercial real estate slump. We have, at least for a couple more years, too many houses and too many strip malls and office buildings for our population and income. Manufacturing is ticking upwards, but from a very low base; car sales may be 20% above their bottom in 2008-9, but remain 30% below peak levels.

Then there's government. The city across the valley from me is likely to go into receivership, lose its charter and revert to town status. Northern Michigan, which I just left, remains depressed. The local marina, which for years provided a big boost to city income, has almost no seasonal slips rented; there used to be a waiting list. Transient rentals and fuel sales were nil on some days the past two weeks. And over everything hangs the fiscal situation of California and Illinois. State and local government continue to lay off employees, even as the Federal government has stopped hiring.
So how do you like your cone? We're an obese society; we had an obese economy. Double-dip goes without asking. But there is a triple-dip crowd. You have to beg for a single dip, and we're not doing that.

Part II

Congress seems to be (wrongly) spooked by deficit hawks, and may go into reverse mode. Ironically, by prolonging the recession(s), that will leave us in a worse fiscal position, because most of our current deficit is the result of slow growth – falling revenues – and not a burst of expenditures.

Unfortunately post-banking-bubble recoveries tend to be slow, because it is structural distortions (too many houses) that have to be unwound, and short of buying up and bulldozing new developments, there's no quick way to do that. (We also have a growing population, so we will eventually have demand, and when retiring baby boomers can sell their houses, that will spill over even into such examples of excess as Las Vegas.)

A new working paper by M. Miyazaki from the International Monetary Fund makes the (with hindsight!) obvious point that the news is worse than that: revenues tend to grow with the economy, not faster than the economy, and so are very slow to recover to earlier levels. (See In Search of Lost Revenue, which is at the non-technical end of the spectrum of IMF working papers: you don't need an economics PhD to read it.)

Now it's conceivable that we could cut expenditures to speed the process. But we seem to have a proclivity for war, and for getting older. While I'd like to see us change the former, I have a vested interest in the latter, as does everyone reading this. And demand for most of the rest of what the government does, federal, state, and local, is a function of population. The US has a small government, in international comparison, so it's hard to find ways to significantly cut expenditures. Plus the last time I looked, we could cut all non-defense, non-aging related expenditures at the Federal level and still have a deficit.

Let's not kid ourselves: if revenue doesn't recover on its own and since expenditures can't be cut, then at some point we need to enhance revenues. A lot. My preferred alternative would be a national value added tax.

But demagoguery aside, there's no urgency; interest rates remain at record lows, and not just on short-term debt. However, we can't wait a decade before doing so. Hence even if Obama does not do so – it's hard to see that happening – the next president must. It will be a disaster if the radical right trumps conservative sensibility and precludes that presidential campaign from being over how to raise taxes, not whether to raise them.

Mike Smitka

No More Clanging Clunkers, No More Sales

Mike Smitka

What, now that the clunkers program has clanged to a close? In a couple days we'll see what total August sales were like – I'm risking bytes of criticism writing now – but I'm afraid it will be back to business as normal. Afraid, because normal this year has been an SAAR of 10 million or less. The level of enthusiasm makes it clear that sales have been pulled forward; it'll be payback time. The problems run deeper: cars were affected by the bubble, and not just housing.
A recent NBER working paper by Atif Mian and Amir Sufi of the University of Chicago bolsters the argument that I've made in earliers notes. My analysis was based solely on an analysis of sales and scrappage data relative to the vehicle stock; they started out with data on 266,000 individuals in the Equifax credit rating database. (Don't worry – they couldn't actually look at individual records, but instead had to extract information from data that Equifax had already sanitized and then mildly aggregated.) But combined with data on geography and housing prices and demographics, they could paint a picture of where prices had gone up, areas where housing supply was "inelastic" so that shifts in demand showed up as higher prices rather than more construction. They could then look at who borrowed: not those with in places where prices moved little, but those who were in "hot" markets, and who started out with lower incomes and/or lower credit scores. And did they ever tap the equity; credit records made it clear that these people were also buying a lot of vehicles, vehicles they earlier had not been able to afford. But those same locations are ones where mortgage holders are now under water (see Federal Reserve data on credit conditions, illustrated by maps color-coded at the county level). They're losing their houses and their cars, not buying new ones. In other words, there was a bubble in the auto market as well, people buying on credit backed by unrealized capital gains.
That really is not news, though it makes for sobering and poignant stories (see the New York Times series on the Beth Court neighborhood in Moreno Valley, outside LA). But what Mian and Sufi show is that behavior didn't change much in the many urban areas where there was no run-up in housing prices (I'll append a graph I created from the Case Schiller real estate index that illustrates the contrast). In other words, the big boom in car sales came from the same people who were splurging on home renovations and vacations by pulling equity out of their houses. Well, that equity isn't there to the tune $1 trillion in California alone (data from an August 13th study by First American CoreLogic). In Nevada 45% of homeowners have negative equity of 25% or more of their mortgages; in California, 25%. These people aren't buying cars anytime soon. So while house prices may have bottomed out – and the recession ended – that doesn't mean the good times will roll again.
That's not only because of all the people who lost everything (or soon will, given that 5% of the labor force has now been unemployed for over 27 weeks, and another 2% for 15-26 weeks). On average the rest of us are worried. State and local governments are only now cutting their budgets; commercial real estate hasn't hit bottom yet. There are a lot of pink slips yet to be distributed. So there's no reason to think those of us who were more conservative in our habits are suddenly going to loosen pursestrings that long have been tight. Let's be honest with ourselves; if we're thrifty, it's by necessity: home equity is what we have from paying down the mortgage, not because the spot of mother earth we occupy was suddenly worth megabucks

The graphs below look at housing prices relative to the CPI index, real GDP and nominal GDP. One focuses on four of the metropolitan areas with the greatest run-up in prices, a couple of which have come back to earth, and then some. The other highlights cities where there was comparatively little change. I left the scale the same on both, which results in a lot of blank space on the second one, plus it's hard to read because the graphs lie more or less on top of each other. Which is the point it is meant to illustrate.

Here's a link to a powerpoint from a talk I gave yesterday (Aug 25, 2009) that includes additional material.

Click to enlarge!

Click to enlarge!

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Chrysler dies; bailout a success

Mike Smitka

Quite frankly, I don't expect Chrysler to last the year. Indeed, I would be surprised if the "new" Chrysler, to be announced before the end of June, will be successful in relaunching production. Too many of its suppliers are on the wrong side of the brink. At the low volumes of production that will prevail while 100 days of inventory remains in the system, it won't pay for them to keep the parts flowing to Chrysler's assembly plants. All it takes is one crucial supplier to say "no" – or to be unable to finance restarting production – and it's the end of the line. In several senses.
Nevertheless, I judge the Chrysler "bailout" to have already been a success.
Why? Well, let's think of the timing. Back in December 2008 the financial system was still close to implosion, as was General Motors. Confidence across the economy lay somewhere between gloom and doom. At the time Chrysler clearly was not viable – not that that has changed, with or without Fiat. The "rescue" is in that sense a bit of a misnomer, because the patient will never be resuscitated. With the final denouement, billions in government funds will vanish (I don't want to count, but remember there is indirect lending via the government-owned GMAC, not just the direct "bailout" money).
But given the timing, a Chrysler collapse Christmas 2008 would have been a present worse than a lump of coal in a child's stocking. It would have been fat on the fire of prevailing fear, marginal financial institutions burned critically. GM would have seen suppliers shut their doors, and once that happened, Toyota and the other new entrants ("Detroit South") would likewise have had to shut their assembly lines. Three-quarters of a million workers would get the post-Christmas message that for the time being they had no job to return to. The spin-on from that ("multiplier effect" in economist's lingo) would have been horrendous; unemployment would have jumped almost overnight to double-digit levels.
Now the economy can handle Chrysler's liquidation, and (with less assurance) that of numbers of key suppliers. GM will not collapse; financial panic has been quelled, and that Chrysler was expiring would not be news. Detroit would be in mourning; even I might shed a tear, since I paid college tuition with summer jobs at Chrysler plants. But the economy would not be pushed over the brink.
And I might be wrong. Chrysler has lived from crisis to crisis. But this time around I don't think they'll make it.

PS: David Ruggles, who sometimes posts here, makes a parallel argument from the "downstream" dealer side: no responsible financial institution will make loans to a Chrysler dealer to finance their inventory (offer "floorplan" in industry jargon). Nor should they finance consumers at more than (say) 50% of purchase price, given the uncertain value of Chrysler products as collateral. If indeed banks behave as banks (GMAC, under government ownership, isn't), then Chrysler will have no dealers left to whom they can sell vehicles. End of story.
I made this point in a forum at the Auto Finance Risk Summit in Miami on 20 May 2009, organized by Royal Media Group. Thanks to a discussion forum there for stimulating me to make various "devil's advocate" arguments. I've concluded that this line of argument is (sadly) more than just a good debating point.