By Randall Coleman, Portfolio ManagerGroundhog Day was a week-and-a-half ago but it seems to have had a delayed reaction. Just like Bill Murray’s character in the movie, it sure feels like we’ve been here before. This was a definite “risk off” week, with volatility (CBOE VIX Index) popping above 30 and the S&P 500 seeing its biggest 2-day drop since September, 2020. Causing much of the strife was an eye-popping CPI number released Thursday. The 7.5% print shows inflation running at a pace not seen in the US since the 1970s. Geopolitical intrigue with the possibility of Russia invading Ukraine further spooked investors into pulling back from equities.
When the market loses its sense of humor, i.e., volatility spikes, big down moves and the like, it is instructive to take a closer look at some of the market drivers. Today, I’d like to concentrate on a particular niche where inflation is running white hot: used cars. Year-over-year used-car prices leapt over 40% in January, clearly showing imbalance in what is normally a pretty boring area. The old Econ 101 textbook will help with a quick refresher to make some sense out of this seemingly impossible environment and see how it can resolve itself.
First of all, things are upside down. Conventional wisdom and historical evidence say that automobiles are a depreciating asset. The rule of thumb is (or was!) that a new car was worth 80% of what you paid for it the moment you drove it off the car lot. Cars are supposed to be worth less with each additional year. That’s the normal environment. Today’s environment is abnormal.
US CPI Urban Consumers Used Cars & Trucks NSA YOY% – Bureau of Labor Statistics
Source: Bloomberg, Bureau of Labor Statistics
The 20-year average (ending January, 2020) for the year-over-year US CPI Used Cars & Trucks Index is negative 0.3%, meaning their prices go down every year. The graph above shows that number shooting up to over 40% at the end of 2021. What is going on here?
This is where pulling the page out of the Econ 101 textbook helps. Everybody remembers the Supply and Demand curves, right? With Price on the y-axis and Quantity on the x-axis? Regardless, the salient point is that the Supply and Demand curves intersect at a point of equilibrium—where quantity supplied equals quantity demanded and price is determined by that equilibrium.
That’s the normal environment. The problem today is that there is very limited supply of new cars. New car production has been thrown into disarray with Covid-related production halts, supply-chain disruptions, semiconductor shortages, power outages, and on and on. With no new cars, drivers are holding on to their used cars longer and longer. This dynamic has severely limited used-car dealers’ ability to obtain inventory. In the graph above, the blue (supply) line has shifted to the left, meaning that the equilibrium price moves up along the red (demand) curve to a higher price. At the same time, though, the red (demand) curve for used cars has shifted to the right, since more consumers are looking to buy used cars, absent available new cars. That pushes up the prices of used cars even further. That is the mechanics of economics in action.
Elasticity of demand is another term that helps make sense of the current environment. Elasticity is essentially sensitivity to price. Products with high demand elasticity are very sensitive to price: buyers will buy lots more at lower prices and sharply less at higher prices. Products with low demand elasticity face a consumer who is insensitive to price. Buyers will pay whatever it takes to get one. The lack of new cars has altered the elasticity of demand in the used car market, making desperate buyers more insensitive to price than they normally would be. Buyers are “biting the bullet” because they have no alternative. Their sensitivity to price increases has turned inelastic.
Is there an end in sight? Yes, but it takes time. To break the logjam in new car production, producers and suppliers all along the supply chain are addressing inventory shortages and supply issues. Semiconductor makers have shifted production to automotive specific chips. The response is coming, but it can’t happen overnight.
It sounds simplistic, but the only way to get to the long term is by going through periods of short term. We’re in the short run phase now. Nothing can adjust but price. Suppliers cannot materialize cars and parts out of thin air. The necessary ingredient for equilibrium is for a supply response to kick in. It is happening. Economic rents (profits well above cost plus a reasonable margin) are always competed away. Today’s environment where used car prices go up 40.5% year over year is simply not a sustainable environment.
A broader implication of this exercise is that, at least in used-car prices, next year’s CPI measure will be lower than this year’s. Used-car prices account for a tiny slice of overall CPI, but at least in this measure, there is relief in sight.
We are seeing similar dynamics play out across all our portfolio positions at ACM. Companies adjust and adapt in the short run in order to flourish in the long run.
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