BLOG: VW scandal and China slowdown are taking the shine off autos

Written by: Jake Robbins
At first glance the auto industry should be feeling pretty good about itself; sales in the US have continued to recover strongly since the financial crisis and could well reach record highs in the next year or two.

Europe has also seen a marked improvement in volumes over 2015 as low interest rates and a gradually improving economy have boosted sales. And because customers held off from buying new models during the bad years, the average age of a car is now far older than historic levels which should support stronger growth for some years as they get replaced.

However, as we know, all is not well in the industry and there remain significant uncertainties for producers that cast a long shadow over the industry.

The first great problem that the industry has had this year is a sharp slowdown in demand growth in China. For most manufacturers this has been the fastest growing and most profitable market by far, and most companies’ long term growth plans revolve around building more capacity in that part of the world.

Sadly, just as production has ramped up, demand has actually fallen for most of the year, negatively impacting pricing and therefore margins and profits. With China’s economy unlikely to reaccelerate any time soon, this market might not be the golden goose that the industry had thought it was even just a year ago.

Secondly, VW has sparked the beginnings of what could be an industry wide emissions scandal, potentially rivalling scandals in the banking sector. Whilst deliberately installing software to cheat on its emissions tests seems at the moment to have been solely a VW wheeze, their admission that many of their cars simply do not perform as well on emissions as they claim (and indeed in many cases the law demands) is almost certainly an industry wide issue.

It seems to be an open secret that emissions tests have been conducted in an utterly unrealistic environment with the full knowledge that a car on the road would produce significantly more emissions than those claimed in testing. With investigations ongoing globally, at the very least the costs of fixing these issues for manufacturers will surely rise. And the problem for an industry such as autos, with huge fixed costs and wafer thin margins, is that any increase in cost can have an horrific effect on profits. This is particularly the case if you are a mass producer rather than at the luxury end of the market, as pricing is very difficult to increase owing to the many producers and intense competition.

So, with their main highly profitable growth market already slowing, and the costs of the emissions scandal yet to be felt, it is difficult to be too optimistic in the short term on the auto industry. However, as always some companies will succeed through superior products and market share gains and some will lose. But beware the operating leverage in these businesses, as a small change to sales or costs can have an extreme effect on their bottom line.

Jake Robbins is manager of Premier Global Alpha Growth fund

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