From Sour to Sweet

Here is why the automotive industry might pick up steam just as the broader economy cools down.

While we’re all eagerly waiting for the arrival of the Great Recession 2.0, the US automotive industry has already been in a recession for almost two years. There is significant pent-up demand for vehicles after years of underproduction. Falling interest rates might ignite this demand over the course of this year. The automotive sector might turn sweet just as the broader economy turns sour. I would be surprised if any of that is priced in. It feels insane making the case for cyclical stocks at this point in time. But perhaps that is precisely why it makes sense?

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Out of Sync

There is A LOT of debate at the moment regarding THE upcoming recession. I am not sure when this debate started, but we must have been talking about it for a year now. And yet, 1Q23 will likely be again a quarter with strong or at least solid economic growth.

For many observers, this is confusing because there are clear recession signals from various indicators that have been very accurate in the past in predicting recessions.

While it appears plausible that we will see an economic slowdown, I believe it is unlikely for us to hit a big GFC style recession. To me, it is quite obvious that we are already in a rolling recession where various industries continuously enter and exit recessions. Because of the economic disruptions in recent years (pandemic, energy shortages, geopolitics etc) many industries are out of sync with each other. As a result, we’re not seeing these industry-specific recessions in the aggregate GDP because for every recessionary industry, there is always another one picking up the slack.

At first, we had the lockdowns that sent hospitality and transportation into recessions which was covered by consumer (durable) goods and digital services. As the former recovered after the reopening, digital services suffered. When the aftermath of the lockdowns caused inflation spikes, goods went into a recession. But strong demand for energy saved the economy (in the US at least). Rapidly rising interest rates were the response to the inflation spike. As a result, capital intensive industries such as vehicles and real estate suffered. But capital light industries, particularly services, were not much impacted and continued strong.

This is obviously a highly simplified summary of the last three years. But I hope you get the gist of it. We have not been in a normal economic cycle in the last couple of years that would be driven by naturally over and undershooting economic production and consumption. Instead, external shocks from lockdowns, wars and manic monetary policy swings have overshadowed the normal economic cycle.

The Auto Recession

When you consume an asset, it does not matter whether you lease it from someone, whether you buy it for cash or whether you finance it. You will always pay its cost of capital. When you lease, you pay the cost of capital to the owner. When you pay with cash, you pay with opportunity cost as you could have deployed that capital for alternative productive purposes. And if you finance it, you pay the cost of capital to the lender.