Special Report

December 07, 2020 | 08:30

Autos V-eer Around COVID-19

Economist

Economist
Economics

Erik conducts research on financial product market trends, emerging risks and macroeconomic trends for the Bank.... (Read more)

Erik Johnson

Economist
Economics

Erik conducts research on financial product market trends, emerging risks and macroeconomic trends for the Bank.... (Read more)

Highlights

Vehicle demand decelerated amid COVID-19 in 2020, but the sector has managed to chart a V-shaped recovery
2021 sales are likely to hit just under 2 mln units in Canada and 15.6 mln units in the U.S.
Potential vaccine distribution by 2021Q2 offers upside to the sector

V-eering Around COVID-19

Early in the year, the outlook for the global auto industry looked dire. Dealerships were temporarily shuttered and production was halted as the global pandemic caused the shortest and steepest post-war recession on record. Still, vehicle sales have managed to chart a V-shaped recovery. Light vehicle sales in Canada and the U.S. will likely be down 15.5% (Chart 1) this year, much better than the most severe scenarios but vastly different from the pre-pandemic forecast of a 3.7% drop. The resilience of consumer spending on durable goods, chief among them vehicles, has been a welcome surprise. In the United States, sales volumes are likely to drop 15.1% this year. In Canada, more stringent public health restrictions left a bigger hole to climb out of and, accordingly, vehicle purchases are likely to decline 18.7%.

Zooming out on the year, however, the auto industry has managed to steer clear of more severe economic damage. While the momentum built up over the last several months could take a hit amid surging COVID-19 cases in both countries, we see sales accelerating in 2021. Robust fiscal and monetary support in Canada will likely propel light vehicle purchases to just under 2 million units in 2021. The biggest drag on sales in Canada, household debt, has also been shelved for now, as short-term interest rates are unlikely to lift off until after 2023, keeping debt-service ratios lower. We see the year ahead for the U.S. with more caution, with sales reaching 15.6 million units. The expiry of the CARES Act income-support programs could slow sales growth to start 2021, and attractive interest rates for vehicle financing will be counterbalanced by slower population growth and waning consumer confidence. With the potential for a vaccine seeing wider distribution by 2021Q2, we could see U.S. fleet sales recover more quickly, which could add as many as 1 million units.

Learning From the Past

In the Great Recession, financial market stress cast a long shadow on vehicle demand. Tightening credit standards and weak consumer demand kept auto purchases low for years. Not wanting to see history repeat, policymakers responded aggressively to normalize both lending rates and household incomes during this year's downturn. Banks tightened lending standards and consumers stayed away from shuttered dealerships when the pandemic took hold in the spring (Chart 2). But those trends quickly reversed with shutdowns easing and the Federal Reserve cutting rates, which encouraged vehicle sales.

We also saw aggressive steps taken by the Bank of Canada to stabilize financial markets in early 2020. The bankers' acceptance (BA) market showed significant stress as spreads widened in mid-March, but the Bank set up the Bankers' Acceptance Purchase Facility (BAPF), which helped normalize spreads by mid-April (Chart 3). The BA market is an alternative financing source to asset-backed commercial paper and thus plays an important role in the auto lending market in Canada. Easing credit conditions and low interest rates provided relief to vehicle sales this year.

On the fiscal side, both Canada and the U.S. quickly opened their wallets to stabilize household income during the pandemic. And the spending was immense with the IMF estimating that, among the largest 15 economies, Canada had the most significant fiscal response followed by the U.S. That fiscal support has helped create an unprecedented situation where consumer spending was falling while disposable income surged.

Saving For The Future

There were significant disparities in the labour demand shock from the pandemic, with new vehicle buyers more insulated from job losses than lower-income workers. When dealerships reopened after the initial wave of shutdowns, the average auto consumer was well-positioned to resume spending. This was borne out by the quick rebound of vehicle sales over the late-spring and summer.

While the lift to auto sales provided by pent-up demand will slow in 2021, recently accumulated household savings in both Canada and the U.S. will continue to support new vehicle demand. In October, durable goods purchases were still 15% higher in the U.S. than February and the household savings rate remained well-above pre-pandemic levels at 13.6%. With spending on services still limited by the virus, durable goods will continue to benefit from elevated household savings and muted spending on services heading into 2021.

Immigration will be a headwind in both countries to start 2021, as COVID-19 significantly hampered efforts to settle new residents. Canada remains better positioned on demographics though, with population growth around 1.1% for 2020 and the federal government setting more ambitious immigration targets for future years. In the U.S., population growth continues to be a drag on vehicle sales, as it is on track to come in at only 0.5% this year, half the past half-century mean.

Another major headwind on the horizon in the U.S. is the likely expiry of remaining fiscal support programs. President-elect Biden indicated support for further pandemic relief, but getting a deal through Congress will require cooperation from the Senate, which won't see elections resolved until Georgia's run-offs in January and is likely to remain in Republican control. As of November 7, 13.7 million Americans were receiving benefits through unemployment insurance programs that are set to expire at the end of the year. This could lead to households cutting spending, thereby stalling the recovery.

Production Gets a Boost

Auto manufacturing all but ground to a halt in April, and the spring slowdown hit inventories, which fell to lows in the U.S. last seen during the aftermath of the global financial crisis (Chart 4). However, production normalized over the summer, carving away part of the shortfall from the spring. As of October, production in the U.S. was down 20% year-to-date, which is not far off where demand will end up for the year. Looking ahead, if the virus remains under control, automakers should be able to keep pace with anticipated demand for 2021 models. Used vehicle supply should also get a boost as fleet usage returns to more normal levels.

At the start of the year, Canada's vehicle production prospects looked bleak. GM appeared set to wind down much of its assembly in the country. That presented risks to the health of supporting industries across Ontario. FCA also announced its intention to shutter its third-shift in Windsor, cutting a further 1,500 jobs. Canadian vehicle production had long been in similar proportion to domestic sales at around 2 million units (Chart 5). With both GM and FCA originally set to reduce their presence in Ontario, the auto sector was expected to contract, having suffered closures each equivalent to around 7% of production in two years. And Canadian production slowed more than in the U.S. this year (-26% YTD), as the lack of production in Oshawa compounded the closures related to the virus.

Fast-forward to November, and each of the "Big Three" have announced at least $1.3 billion of investments in their operations in Canada. GM's surprising decision to reopen the Oshawa plant by late 2021 will add production capacity of around 240,000 vehicles. With these investments, auto sector employment will grow for the first time in years. And compared to past labour agreements, each deal represents investment in growing vehicle segments (think trucks and electric vehicles) rather than conventional passenger cars, which had long been a weakness in FCA's presence in the country (Chart 6). That's a big deal for the broader Canadian economy with auto and parts production representing 9% of manufacturing.

The USMCA Era Begins

Despite the new North American trade deal going into effect on July 1, automakers were given two reprieves: compliance was delayed until the end of the year and penalties may be waived for up to one year. The good news notwithstanding, the longer term impacts on the industry point to increased costs. Analysis from the CBO suggests that the extra costs could total nearly $3 billion over the next decade, as more vehicle supply may shift to paying the 2.5% import tariff instead of achieving complete compliance under USMCA [1]. Those higher costs would be borne, in-part, by consumers, which could slow demand.

But the early signs, at least for Canadian automakers, suggest a shift toward broader compliance. With GM reallocating most of its production capacity to assemble light trucks in Canada, this will further boost the North American content of its Canadian production mix. GM's Canadian-made vehicles stood at 60% North American content on 2020 models, and increased light truck production should push the share above the 75% threshold (Chart 7). Ford and FCA similarly took steps toward meeting the new USMCA regulations, as electric vehicle assembly (with batteries accounting for up to 40% of unit value) will further elevate their North American content production shares.

The wider supply chain is still operating under the pre-USMCA status quo in the U.S. Despite major disruptions in Mexico earlier in the year, auto parts import patterns have returned to their pre-USMCA trends (Chart 8). A shift toward more electric vehicle production in North America and further consumer enthusiasm for the light truck segment could pave the way for further re-shoring of production inputs.

The Aftermarket Puzzle

The sudden shift to the work-from-home model pointed to potential trouble for the aftermarket industry, as drivers were poised to reduce their demand for parts and service. But that is not how the year played out. Retail sales at auto parts and accessory dealers are outpacing vehicle purchases in Canada, down only 4% year-to-date (Chart 9). In the U.S., they are even stronger, nearly on par with last year. Limited travel options over the summer and the surge in demand for used vehicles this year likely helped make up for the shortfall from less urban commuting and new vehicle sales.

With a potential vaccine on the horizon, there is further upside for vehicle use. Despite the rosy aftermarket spending trends, U.S. vehicle miles traveled were still down 9.7% y/y in September. Real-time data also suggest that urban traffic congestion remains well-below 2019 averages (Chart 10). A reversal of work-from-home trends would likely increase vehicle use for commuting in 2021, providing further support to the sector.

Bottom Line: Despite the severe economic repercussions of the pandemic this year, the auto sector has avoided the worst case scenarios and is headed for a brighter 2021, assuming the pandemic is brought under control.