Grant's Almost Daily,

CPI Heading Lower Soon?

Consumers slammed on the brakes. The September CPI reading marked a second straight downside surprise, as the headline 2.3% year-over-year uptick was shy of the 2.4% consensus estimate and well off the 2018 high of 2.9% notched in June and July. There was one particular culprit behind the drop:  The “used cars and trucks” category saw a 3% sequential decline, by far the biggest move in the 37 subcomponents which make up the broad CPI index.

The CPI contradicts more widely cited commercial data. J.D. Power and Associates reported in its September Industry Update that its price index hit a near three-year high in August, up 5.4% year-over-year. Of the strength in used-vehicle prices, J.D. Power commented: “there are no signs of it letting up.”  This afternoon, J.D. Power released the September figures, which featured a modest 0.4 point sequential decline to leave the used vehicle index near those post-2015 highs, up 2.5% year-over-year.

However, there is reason to believe that the government’s data signal something important. In January, the Bureau of Labor Statistics tweaked the methodology for the used cars and trucks index to a one-month price change adjusted for depreciation, from the prior formula of three-month moving average, adjusted for depreciation, in order to “improve timeliness.”

Daniel Ruiz, founder of automotive research firm Blinders Off, LLC, likewise believes that a sea change has recently taken place. Ruiz reports that his proprietary data indicate that growth in inventories of used vehicles piled up throughout September, rising from 3.19% above their 2017 levels in the first week of the month to 6.24% year-over-year by week four. At the same time, used-vehicle prices dropped precipitously in that same fourth week of the month. Ruiz explains the connection in a recent blog post:

The sudden increase in used vehicle inventory is a strong signal that the rate of sale has slowed due to price increases that consumers are not willing to absorb. Most retail dealers have a rigid 60-day cut off for used vehicle inventory. As a vehicle nears the 60-day mark, the dealer is forced to heavily discount that vehicle or face an even greater loss by disposing of it through wholesale auction (60 days of depreciation, reconditioning expense, transportation and auction fees).

This is also likely related to the sharp drop in used vehicle values during week four of September as retail dealers returned to auction and adjusted their bids after realizing the vehicles they previously purchased did not sell at the prices they anticipated.

Reached by Grant’s to discuss his findings, Ruiz reiterated that the drop in September used-car prices measured by the CPI reflects dealers trying to clear inventory, stating that he’s “fairly certain this will show up in the numbers in a big way.”

Ruiz went on to explain the value of used vehicles as a barometer of overall industry health. After all, used prices are critical for new car sales, as almost all transactions involve a trade-in. In particular, bearish recent price action in Ford Motor Company and General Motors Company (each down about 30% since June) may be discounting significant operating pain ahead.

Used car prices are critically important.  As loan terms have increased through this cycle, the time to equity increases [i.e., it takes longer for a leased vehicle to accumulate positive value at trade-in], meaning a drop in residual values has major implications for demand for new vehicles.

The rate of change (both buildup in inventories and decline in used car prices) is extremely fast. This will hurt the automakers in two ways:  Incentive spending will need to rise, which hurts margins. If increased incentive spending fails to stabilize inventory levels, production will need to fall, which hurts volumes. The OEMs will not be able to respond immediately, so the fourth quarter and first quarter of next year could be ugly.

There are other indications that the CPI may be heading lower in the near-term. According to the September market report from real estate website Zillow Group, Inc., median nationwide rent declined 0.2% year-over-year in September, the first negative reading in six years. For context, the shelter component is given a 32.9% weighting in CPI calculations.