Commentary: Sorry Detroit. The Garage Is Full

Demand may slow as rates rise and incentives fall

Michelle Pollak has a seriously crowded garage. In the past three years, Pollak has added three new cars to the family fleet, bargaining for cheap deals on her Volvo (F ) wagon and her husband's Lexus SUV. The couple even picked up a slightly used Honda (HMC ) minivan for the au pair, who cares for their two kids. Including an old Mazda RX-7 convertible and an aging minivan, the family now has five vehicles. Says Pollak: "We're not adding cars anytime soon."

If many more Americans decide the garage is full, carmakers could be headed for a patch of rough road. Thanks to low interest rates and ever-sweeter incentives, sales have been sky-high for five years. Company execs, pointing to a stronger economy and millions of young drivers coming on stream, expect robust sales to continue. But with rising rates almost certain to make car payments pricier, some economists question if enough eager shoppers still exist to keep sales humming -- let alone spark the kind of growth that would let Detroit slash rebates and rebuild profits. Says Bank One Corp.'s (ONE ) ex-chief economist, Diane Swonk, who recently started a new venture: "Sales are artificially high."


Why the gloom? For the past three years, as auto makers have thrown ever better deals at buyers, sales have remained essentially flat at around 16.7 million vehicles. Even if sales hit about 16.8 million, as analysts expect, that won't be enough to help Detroit. Ford and General Motors (GM ) are already having a tough time making money selling cars, while Chrysler (DCX ) has only recently gotten a lift from some hot models. And if rising rates cause sales to drop, look out. Swonk and some other economists say sales could fall as low as 16 million in 2006. That may not sound like much of a fall, but the impact would be huge. Comerica Bank Chief Economist David Littman says once sales fall below 16.25 million, it will be difficult for the Big Three to stay in the black.

Making matters worse, Asian makers are adding plenty of new capacity in the U.S. Already, new additions like Honda's recent expansion of its Odyssey minivan plant in Lincoln, Ala., or Hyundai's new factory in Montgomery, Ala., are putting pressure on Detroit. And over the next two years, the Japanese and Koreans will bring online enough extra production to build 600,000 more vehicles in the U.S. each year. Presuming those cars find buyers, the market would have to increase by the same amount to prevent Detroit from losing sales. Says Deutsche Bank (DB ) auto analyst Rod Lache: "We have a lot of headwinds."

Those winds seem unlikely to cause much damage until 2006, say most analysts. True, the banks' prime lending rate has risen one percentage point, to 5%, this year. But with rates still near historical lows, auto makers have been able to continue offering attractive incentives. Economists expect rates to remain close enough to today's levels in '05 that auto makers will continue to be able to load on the deals. Just as important, Littman notes real disposable income is still growing more than 4%, which augurs well for sales through the next year.

But by 2006, higher rates could start to pinch, making it harder for auto makers to offer cheap financing. Goldman, Sachs & Co. (GS ) analyst Gary Lapidus estimates that, unless the economy improves, a one-point rise in rates over the next 18 months or so could trim sales by up to 600,000. That would push sales down toward 16 million vehicles -- a level not seen since 1998. To offset that, he says, average incentives would have to rise an additional $1,100, to about $5,000.

Uncertain Road

GM has already moved to counter rising rates. The auto giant is offering buyers a chance to lock in 0% or other low-interest loans for a purchase several years in the future if they buy a car now. It's a risky move: GM doesn't know how high rates will be when buyers come calling with vouchers for lower interest rates.

The big question is whether such deals have let carmakers borrow sales from the future. Americans have shown an astounding willingness to buy more and bigger vehicles. Since 1997 the real value of cars, SUVs, and minivans owned by U.S. households has surged 47% -- twice the growth of residential housing stock. "We pushed up sales by buying them," says Van E. Jolissaint, Chrysler Group's chief economist. "There is certainly no pent-up demand."

True enough. The average household now has 2.1 cars -- an all-time high. And a lot of those vehicles are new. The car fleet is aging, but trucks, SUVs, and minivans -- now half the market -- are on average about 6 1/2 years old compared with 7 1/2 in 1999. And while owners used to replace vehicles every five years, better quality means they're now hanging on to them longer, according to auto analyst R.L. Polk & Co.

What's more, the rich incentives of recent years pulled a lot of people who typically would have bought used cars into the new-car market. Now, rising interest rates could drive them back out. Even if auto makers keep their low interest-rate deals, many of these buyers could face higher credit-card debt or rising payments on adjustable-rate mortgages. As a result, many may have less disposable income available for a new car.

The carmakers, of course, see plenty of reason for continued optimism. For one thing, auto sales don't exceed their historic 3.8% share of gross domestic product -- meaning they are not out of line with the rest of the economy. Car sales do well when consumer confidence and job growth are strong. Both are now on the rise, and auto makers feel the overall economy will remain healthy enough to sustain strong demand. Says Ford Chief Economist Ellen Hughes-Cromwick: "The fundamentals for vehicle-buying should be good."

Eventually, the demographics could favor auto makers, too. The children of baby boomers and the steady arrival of immigrants have added 2 million net new drivers to the population every year since 1999. The U.S. will boast 8 million new households by 2011, says Sean McAlinden, chief economist at the Center for Automotive Research. He believes all those new drivers could help push sales to 18 million vehicles a year by decade's end.

But no matter how rosy the long-term outlook, the industry may be in for a couple of rough years. Over the next two years, the big players will send at least 50 new or freshened models a year to showrooms, up from about 30 in a typical year. Raj Sundaram, president of Automotive Leasing Guide, says the industry needs to sell at least 17.5 million vehicles in each of the next two years to absorb all the new cars. "I don't see how they'll do it," he says. Without some bona fide hits and a reenergized economy, today's packed driveways could mean empty coffers in Detroit.

By David Welch

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