For the better part of the last two years, Western Asset has held a cautious view of the automotive space. While there are positive attributes we can identify, such as the strong balance sheet and liquidity profiles of the major original equipment manufacturers (OEMs) and the collective management team experience in navigating market downturns, the industry has been under siege for the last 18-24 months. Crosswinds span a mix of secular, cyclical and technical factors, which include, but are not limited to: deteriorating industry fundamentals, the blowback from the imposition of steel and aluminum tariffs on Canada and Mexico, volatile raw material input costs, higher fuel prices, structural risks from new entrants and technological disintermediation, poor market sentiment and negative supply technicals.
The latest headwind now comes in the form of escalating tariffs on imports from China and Mexico.
As context around how this risk can impact the US automotive industry, it is important to note that the industry has historically accounted for roughly 3.0%-3.5% of total GDP and roughly 4.0% of the country’s total personal consumption expenditures (PCE). Moreover, there are 14 domestic and international OEMs operating 45 assembly plants in 14 states across the US, with a heavy presence in the South and Midwest—this supports more than seven million American workers with $500 billion in annual paychecks and $200 billion in federal and state taxes. Domestic OEMs also invest more than $20 billion annually in research and development, and help to transform future mobility by investing heavily in automation and electrification.
With this in mind, the impact of a full-blown trade war would severely impact an already fragile sector. For instance, industry analyses show that a 25% tariff would raise the price of an imported car on average by $6,875 and the price of a US-built vehicle by $4,400. Nationwide, if a 25% tariff were imposed, based on FYE 2017 industry sales, American consumers would be hit with an additional tax of nearly $45 billion. Separately, a Petersen Institute analysis projects nearly 200,000 job losses across the industry. In the event other countries retaliate, job losses could reach more than 600,000, or nearly 10% of the auto industry-related jobs in the US.
Simply put, tariffs of any meaningful size or consequence will result in a significant indirect tax on US consumers that has the potential to upend the existing auto sales cycle by reducing overall demand, raising unemployment rates in this sector (as a result of lower production rates), and threatening future investment in advanced engine technologies (hybrid/electric) and autonomous capabilities.
From a valuation perspective, the investment-grade (IG) and high-yield (HY) automotive sub-components were the worst performing subsectors in FYE 2018, as IG and HY spreads widened by 110 bps and 223 bps, respectively. On a YTD 2019 basis, however, IG automotive spreads have rallied approximately 42 bps, primarily on the back of better-than-expected 1Q19 earnings results from Ford, while HY automotive spreads are 7 bps wider given recent weakness in Tesla and Tenneco senior unsecured notes.
While we are cognizant of the fact that there may be additional spread pick-up or carry opportunities available in today’s market, we believe there are simply too many exogenous factors present at this time to warrant a more constructive view and positioning in broad market portfolios. In line with our defensive view, we maintain a preference for companies with strong balance sheets, large liquidity buffers, disciplined capital allocation policies, flexible cost structures and solid free cash flow generation capabilities to help manage through a more challenging operating environment.