The gradual easing of supply side shortages since mid-2022 has reduced production constraints so far in 2023. While this supported stronger-than-expected auto sales in the U.S. for the first quarter of 2023, we expect the momentum to brake modestly for the rest of the year. Gradually rising unemployment and the usual delayed impact of tightening monetary policy on consumers' purchasing power represents a risk to our base case forecast of 5%-7% growth in light-vehicle sales in the U.S for 2023 and 2024. (See chart 1). This is still slightly above our global base-case scenario which includes a very gradual recovery of global light-vehicle production and sales to near pre-pandemic levels by late 2025 (for more details see Global Auto Sales Forecasts: Macro Risks Demand Pricing And Production Discipline, published April 18, 2023).

In the first quarter of 2023, U.S. auto sales increased 8% as residual supply chain constraints eased, vehicle inventories at dealerships improved relative to mid-2022 levels, and sales to fleets resumed. The industry has been operating at near recession-level auto sales for almost three years, and a recovery over the next two years toward 16 million vehicle sales will depend on further supply chain improvements, labor availability at manufacturing plants, and most importantly, pent-up consumer demand. While, in aggregate, households still have a cushion to absorb the back-to-back macroeconomic shocks of high vehicle prices and interest rates, lower-income households, with less savings cushion, are in relatively worse shape. With persistent inflation and rising borrowing costs, even higher-income consumers could be squeezed.

Chart 1

Limited Upside To Most Ratings In The U.S. Auto Sector

Base-case scenario

While S&P Global economists estimate a very shallow U.S. recession in our baseline forecast, the U.S. economic outlook remains uncertain. Financial conditions are likely to weaken further, both because monetary policy works with a lag, and because the economy will continue to slow down amid ongoing stress in the banking sector. We expect U.S. GDP to decline by 0.3 percentage points from its peak in first-quarter 2023 to its third-quarter trough. Such a recession would be the shallowest since 1960.

We do not anticipate substantial downgrades in 2023 as ratings for many issuers are already below pre-pandemic peaks. Most companies rated 'BB'; and above have increasingly focused on reducing debt and building liquidity. Working capital investments and cost inflation will add downside risks to a few weaker issuers, especially if internal cost reduction prospects appear limited.

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. We expect margins and cash flow improvement in 2023 and 2024 to be somewhat limited due to higher interest rates and pricing pressure amid potential demand volatility once supply gradually normalizes.

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

• U.S. auto sales increase to 14.7 million units in 2023 and over 15.5 million units in 2024 before surpassing 16 million units in 2025, still below pre-pandemic levels.
• We expect average new vehicle prices to fall about 5%-7% and more demand to shift away from new to used. However, used prices may remain roughly flat in 2023 as tougher financing conditions on the demand side are offset by a limited supply of used vehicles (especially for popular segments), and persistently high new vehicle prices. Steady used vehicle prices could also further limit declines in new vehicle prices. The average age of vehicles in the U.S. remains high, at over 12 years in 2022. This will likely boost replacement demand for some older vehicles given the supply constraints of the past two years.
• For automakers operating in North America, the combined impact of marginally higher production volumes and lower commodity costs could offset most other cost inflation in 2023. However, we do not assume material recovery in profit margins or cash flows given pricing and product mix pressures amid tough macroeconomic conditions, higher costs related to elective vehicles (EVs), and potentially higher costs associated with negotiating a new contract with the United Auto Workers (UAW) union in the fourth quarter.
• 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.
• Suppliers will likely start to show improvement in both margins and free cash flow going forward as raw material and freight inflation moderates, volumes improve, and operating volatility falls with less supply chain uncertainty at original equipment manufacturers (OEM) customers. However, labor availability and wage inflation along with overall higher energy prices limit margin upside. We expect 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 these higher costs to OEMs. Lower-rated auto suppliers continue to struggle to pass on higher costs, and we expect these suppliers could also face greater problems refinancing their debt as maturities come due. As EV sales become more substantial over the next couple of years, some suppliers will have to increase investment in research and development (R&D), capital expenditure (capex), and working capital in the form of tooling to support the launch of new products geared to support EVs. While there is the potential for greater revenue opportunities from newer electrification related products, initially this transition will be a drag on margins and free cash flows. The impact on ratings and credit quality will depend on each suppliers' product portfolio and how they navigate the product transition.

Chart 2

Chart 3

With Increased Pricing Pressure, Inventory Management Will Be Critical

We believe volatility in automakers'; sales (table 1 and chart 4) could persist over the next few months especially because of the differences in inventory levels at the end of the first quarter across automakers. We expect most automakers with products skewed toward light trucks, especially pick-ups, to target around 50-60 days of total dealer inventory on a portfolio basis. That is down over 30% compared to pre-pandemic levels of 80-85 days (in mid-2019) for light-truck focused automakers.

Table 1

Light-vehicle inventory totaled 1.8 million (per Wards AutoInfobank) at the end of March 2023, nearly 50% higher than a year ago. Light-vehicle inventory at dealerships reflected 36-day supply, up from 26 days a year ago, but down from 39 days at the end of January as demand improved with growing inventories. There is some divergence emerging between OEMS, with some companies like Stellantis and Ford at higher inventory days and other companies like the major Asian players (Toyota, Honda, Nissan, Hyundai) still at very low days' supply. These differences will likely lead to some variation in the level and timing of incentives and pricing reductions for different carmakers. We expect the initial price reductions to reduce new vehicle gross margins at dealers who have been charging well over the manufacturer's suggested retail price (MSRP) for certain models and keeping the additional profit.

As supply chain bottlenecks abate, we expect most automakers with a heavier-truck mix to target around 50-60 days of total dealer inventory on a portfolio basis. We believe this improves auto retailers'; profitability (due to lower costs on floor plan financing) and productivity, as it lowers incentives and reduces complexity for automakers (more order-based) in a go-to-market approach.

Chart 4

Rivalry In The Pickup Truck Segment Will Intensify As Supply Restores To New Normal Levels

In the first quarter, pickup truck sales increased around 8%, in line with the overall market. Historically, pickup truck demand has had a strong correlation with housing starts (chart 5). 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 as inflation depletes household balance sheets. We reduced our forecasts for housing starts for 2023 and 2024 to 1.2 million, down significantly from 1.6 million in 2021 and 2022. While this could indicate a headwind for pickup truck sales, we expect this to be offset by pent-up demand in recent years (due to supply constraints) to replace ageing pickup trucks. 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 2023 (table 2). If pressure in the housing market persists beyond 2024, it could limit growth for this highly profitable segment and introduce fierce pricing pressure.

Chart 5

Table 2

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

While average cumulative household savings have declined since 2021--when they were $2.5 trillion above 2019 levels--they're still about $1 trillion more than in 2019. With help from a still-healthy jobs market that is keeping wages elevated, households have a cushion of significant excess savings that is being depleted--but slowly. With a shortage of new and used vehicles inflating prices, lenders are still willing to support loans of 72-84 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 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 represented an all-time low of 15.3% in the fourth quarter of 2022, even lower than the 17%-19% range observed in 2009, post Great Recession. Auto loan delinquencies (over 90 days) have risen throughout 2022, especially among younger buyers. 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 to stay roughly flat in 2023 due to a limited supply of used vehicles (especially for popular segments) and persistently high new vehicle prices. The recovery in used car pricing in the first four months of 2023 indicates how much supply impacts this price given continued reports of weaker demand. Recently, Carmax (the nation's largest used car retailer) reported a fourth-quarter comparable store sales decline of 14% due to inflationary pressures, affordability issues, and weakening consumer confidence.

Electric Vehicle Sales Receive A Boost, But Muted Impact On Credit Quality For Now

In the U.S., the combined market share of EV and plug-in hybrid electric vehicles hit 8.4% in the first quarter of 2023, up from 6.7% in 2022. This positive momentum, boosted by a tax credit in the Inflation Reduction Act (IRA), supports our base case of roughly 20% share of auto sales by 2025. Beyond 2025, we expect lower battery costs, significant model launches, and regulatory proposals (announced on April 12, by the Environment Protection Agency that could tighten emission standards each year between 2027 and 2032) will increase EV affordability. Together these factors will likely help bridge the EV volume gap with Europe and China. 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. As a result, we expect market share losses in alternate fuel segments (charts 7 and 8, table 4) as new model launches challenge incumbents.

The IRA provisions support a modest boost in volume and profitability targets for some automakers, especially those qualifying for the subsidies. In fact, European automakers like Volkswagen, BMW, and Mercedes are announcing plans to produce more EV models in the U.S. with some localized battery sourcing to ensure product competitiveness. However, we believe the act's impact on credit quality will likely be muted in the near term as we expect additional pressure on profits and cash flow for at least the next three years, until more automakers operating in North America achieve the combined benefits of scale and vertical integration. This will significantly benefit automakers that have invested in vertical integration, especially battery capacity. This could lead to a significantly faster path toward lower battery pack costs for these automakers and a potentially meaningful competitive advantage over the next few years.

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 but are falling given recent price cuts, such as the ones from Tesla (see "Tear Sheet: Tesla Inc.'s Strong Profit Margins Facilitate Price Cuts To Protect Its Market Share," published April 21, 2023). According to the Kelly Blue Blook, the average EV price was $58,940 in March 2023, down from around $66,000 at the end of 2022. Battery prices could fall modestly in 2023 after hitting highs in 2022 as lithium, nickel, and cobalt prices have fallen, but significant cost reduction will depend on more lithium refining capacity coming online. 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.

In our view both GM and Ford have adequately invested in EV architecture and vertical integration (including securing battery capacity). However, a higher-than-expected adoption rate for EVs would likely dampen profitability and cash flow in 2023-2025, especially if it cannibalizes the market share of their legacy high-margin internal combustion engine trucks. For more on our views on electrification, see "Credit FAQ: How Will The Electric Revolution Impact The Credit Quality For The Global Auto Industry?", published Oct. 20, 2022, on RatingsDirect.

Chart 7

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Table 3

Related Research

• Global Auto Sales Forecasts: Macro Risks Demand Pricing And Production Discipline, April 18, 2023
• Autoflash EMEA: Car Makers And Suppliers See Past Economic Roadblocks, April 21, 2023
• Industry Risks And The Effect Of EBITDA Stress On Aftermarket Auto Suppliers, April 20, 2023
• Economic Outlook U.S. Q2 2023: Still Resilient, Downside Risks Rise, March 27, 2023
• Industry Top Trends 2023: Autos, Jan. 23, 2023
• Credit FAQ: How Will The Electric Revolution Impact The Credit Quality For The Global Auto Industry?, Oct. 20, 2022