Semiconductor shortages, shipping constraints, and unexpected supply chain disruptions in both Europe and China are likely to persist and weigh on 2022 earnings for most automotive companies we rate. In the first half of 2022, U.S. auto sales declined 18%, including a 13.5% year-over-year drop in June. While consumer demand appears to be holding up, vehicle inventories at dealerships are still lower compared to June 2021, leading to weaker auto sales compared to the first half of 2021 (chart 1).

We expect only a gradual improvement in semiconductor and other components in the back half of 2022 as visibility on shipment times is still low, and inventory for automotive grade analog chips and microcontrollers remains low by historical standards. As a result, we expect U.S. auto sales in 2022 to decline marginally from 2021 levels of around 15 million units. The industry has been operating at near recession-level auto sales for almost two years and a recovery over the next 18 months toward 16 million will be dependent not only on supply chain improvements but on the extent of pent-up consumer demand. While, in aggregate, households still have cushion to absorb the back-to-back macroeconomic shocks, higher prices, and interest rates, lower-income households, with less savings cushion, are in relatively worse shape. With persistent weaknesses in the stock market, higher costs for gasoline and other products, and rising borrowing costs, even higher income consumers could be squeezed.

Chart 1

Recession Risks, Persistent Inflation, And Rising Interest Rates Will Hamper The Auto Sector Stability

Base-case scenario

Credit metrics should stabilize to pre-pandemic levels by late 2023 as most companies will look to preserve liquidity, maintain prudence on reinstating dividends and share buybacks, and limit large debt-financed acquisitions. Though volumes and cash flows in the second half of 2022 and into 2023 will improve compared to 2021, we expect margins and cash flow generation to be constrained due to pricing pressure amid potential demand volatility once the supply gradually normalizes.

In our base-case scenario, we incorporate the following high-level assumptions:

• U.S. auto sales drop marginally to 14.9 million in 2022 followed by a gradual recovery toward 16.1 million in 2023 and remain roughly flat in 2024.
• For automakers operating in North America, the combined impact of marginally higher production volumes and stronger pricing power relative to past recessions will not fully offset cost inflation into 2023. Due to inventory shortfalls, average transaction prices were just under $46,000 in June (per J.D. Power), up over 15% year-over-year, which we believe is unsustainable.
• A key rating assumption is that the industry will exercise discipline while rebuilding capacity toward its revised inventory targets by 2023, which will be roughly 30% below pre-pandemic levels. This will ensure reduced pressure on automakers to raise incentives and lower price, hence protecting their margins somewhat, even if consumer demand weakens over the next 18 months.
• Lower-rated auto suppliers continue to struggle to pass on input-cost increases which will lead to somewhat lower margins and weaker cash flows in 2022, albeit with a gradual volume related recovery in 2023. While suppliers are having more success passing on raw material inflation, there are still lags of several months and differences depending on the commodity. Metals like steel and aluminum general have indexed pass-throughs compared to resins and other materials which require negotiation. We also expect the companies will struggle to pass on high labor and transportation costs.
• Larger auto suppliers, mostly Tier 1, rated 'BB' or above, that produce high value-add components will continue to have more success in pushing through higher costs to OEMs. Cash flow weakness and volatility will persist until production volumes both increase and become more stable.

Over the last 12 months, our ratings have been relatively stable (chart 2), with most negative actions confined to smaller auto suppliers that are struggling to pass on higher costs or are having difficulty refinancing their debt. We currently have a roughly equal positive and negative bias at around 20% each. Companies with a positive outlook have significantly reduced debt (Adient, Tesla) or have restructured their business for stronger profitability (Ford).

Downside scenario

While our baseline signals a low-growth recession, the chances of a contraction (a technical recession) are rising. We assess recession risk at 40% (35%-45% band), reflecting a larger spike in prices with even more aggressive Fed policy heading into 2023. If macroeconomic conditions worsen and GDP growth and consumer confidence falters meaningfully, in our downside scenario, we incorporate the following high-level assumptions, consistent with our recent publication, Global Credit Conditions Q3 2022: Resurfacing Credit Headwinds, published June 30, 2022:

• Auto sales will fall to 14.7 million in 2022 and remain in the range of 15.0-15.5 million units in 2023 (compared to our base-case of 14.9 million for 2022 and 16.1 million for 2023) despite improved supply as affordability dampens pent-up demand.
• Margin pressure will intensify as demand for the highest-margin vehicles could shrink and reduces pricing power for automakers. We do not assume any material shifts away from trucks to sedans given consumer preferences (see chart 3) and industry capacity constraints for passenger cars. Consumers will downsize toward entry-level products within the light-truck segments.
• We assume metal prices (which comprise over 50% of cost of goods sold for auto companies) will remain high relative to historical levels. Metal prices are typically correlated with oil prices and in our downside, we assume Brent crude oil reaches $155 per barrel in the first quarter of next year--50% higher than the baseline--and remains significantly above our baseline through 2023.
• Eroding liquidity cushion will influence downgrade risks for some companies. Despite lower fixed-cost absorption, most large and mid-tier companies have sufficient liquidity to weather a mild recession, or a scenario where U.S. sales in 2023 plateau at 2022 levels before making a slow recovery in 2024. However, a few lower-rated suppliers and discretionary aftermarket suppliers may face distress.
• Acceleration of consolidation, especially within the supply base. With potential for even lower valuations and more distress we could see an acceleration of M&A across strategic and private-equity owners, to enhance scale and insulate some traditional suppliers from disruption trends.

We do not anticipate substantial downgrades in this scenario as ratings for several are already below pre-pandemic peaks. While these companies have increasingly focused on reducing debt, cost increases will add downside risks to several, especially if cost reduction prospects appear limited.

Chart 2

Chart 3

With Persistent Volatility, Inventory Management Will Be Critical

We believe volatility in automakers' sales (table 1 and chart 4) could persist over the next few months. This is because of the differences in product-refresh cycles and in companies' varying access to semiconductors.

Table 1

Light-vehicle inventory totaled 1.2 million (per Wards AutoInfobank) as of June 30, 2022, 12% lower than a year ago. Light-vehicle inventory at dealerships reflected 28 days' supply, up from 25 days in May. As supply chain bottlenecks abate, we think the new normal for inventories could gradually approach 45 days (well below the 20-year historical average of 65) over the next two to three years as automakers and dealers learn to operate more efficiently. We believe this improves auto retailer profitability (lower costs on floor plan financing), productivity, lowers incentives, and reduces complexity for automakers (more order-based) in a go-to-market approach.

Chart 4

Rivalry In The Pickup Segment Will Intensify Once Supply Gets Restored

Due to the disruption in pickup production in recent quarters, we expect some pent-up demand (up to 500,000 units) to boost sales over the next 12 months. Housing starts tend to be highly correlated with demand for pickup trucks (chart 5) and we expect will remain around 1.6 million for 2022, roughly flat compared to 2021. As a result, pickups from Ford Motor Co., General Motors Co., and Stellantis N.V. are likely to remain the top three selling vehicles for 2022 (table 2).

Despite the recent housing boom and slowing housing supply since 2010, mortgage payments have remained under 25% of the average first-time homebuyer's income. With rising interest rates, we expect this number to rise to 26.5% in the first quarter of 2023, the highest level since second-quarter 2006. This will add some pressure to housing starts in 2023 and pickup truck demand as inflation depletes household balance sheets.

Chart 5

Table 2

A Potentially Tougher Financing Environment And Weaker Used Car Prices In 2023 Adds Risk

With a shortage of new and used vehicles inflating prices, lenders are still willing to support loans of 72 to 84 months to attract borrowers with lower credit scores. Moreover, they're frequently offering loans that exceed the value of the vehicle. The downside risk is that it could prevent many buyers from re-entering the new car market for several years because vehicle owners who would usually trade in for a new model could end up owing more than the car is worth. We believe that subprime borrowers are delaying purchases of vehicles for now given higher borrowing costs and inflationary pressures impacting their overall spending.

From a historical perspective, total subprime auto lending hasn't returned to pre-Great Recession levels. Subprime loans as a percentage of all U.S. auto loans averaged below 16% in the 12 months ended March 31, 2022, the lowest since the end of the Great Recession. Notably, captive debt is predominantly owned by prime borrowers and has performed relatively well. Super-prime borrowers (with credit scores greater than 760) accounted for over one-third of all U.S. auto loan originations, the highest since early 2011 and a significant improvement from an average of about 22% in 2006 and 2007 (chart 6).

Chart 6

We expect used vehicle prices will moderate over the next 12 to 18 months as affordability issues emerge and trade-in values decline. Large declines in used car prices will shift demand away from new to used, and hence reduce pricing benefits for automakers. Carvana's first-quarter results indicated weaker demand from buyers of used vehicle, and recently Carmax (the nation's largest used car retailer) reported a first-quarter sales decline of 11% due to inflationary pressures, affordability issues, and weakening consumer confidence.

Electric Vehicle Sales Continue To Increase, But The Cost Of Batteries Will Delay Profitability Targets

Given strong performance recently, we now expect the share of electric and plug-in hybrid vehicles (EVs) to be over 7% for 2022. The faster-than-expected change in consumer preference toward EVs has been due to attractive new models with improved battery efficiency and software capabilities, higher gas prices, and tax incentives. Based on significant launches in 2022-2025 with extended battery range at competitive prices and positive consumer sentiment so far, we forecast electric and plug-in hybrids to at exceed 15% by 2025. As a result, we expect market share losses in alternate fuel segments (charts 7 and 8, table 4) as new model launches challenge incumbents.

Automakers will likely incur higher spending on battery supply chains, but we don't view this as a credit negative now since it allows them to lift production through improved vertical integration. Several battery makers and automakers have announced plans (including joint ventures) to invest in the U.S. as part of an industry trend to meet the expected growth for EVs and reduce dependence on production in China, as well as to manage future supply chain bottlenecks. Prices remain quite high for electric vehicles (over $64,000 according to Kelly Blue Book) and battery prices are set to halt their long-running decline and rise in 2022 and remain high in 2023 because of a surge in the cost of raw materials. Ongoing investments in global capacity, partnerships, and vertical integration will enable automakers to launch affordably priced models and improve profitability within this segment in the next three years. For new entrants and start-ups, the slumping stock market and rising interest rates will persist and make it tough to raise fresh capital from investors.

Chart 7

Chart 8

Table 3

Related Research

• Industry Top Trends Update: Autos North America, July 14, 2022
• Tech Stability Wobbles On Rocky Macroeconomics Despite Anticipated Supply Chain Relief, July 13, 2022
• Economic Outlook U.S. Q3 2022: The Summer Of Our Discontent, June 27, 2022
• Battery Suppliers, Automakers To Take Charge As Prices Rise, May 17, 2022
• The Future Is Electric: Auto Suppliers And The Emergence Of EVs, Feb. 21, 2019