Wednesday, April 12, 2017

Is There a Bear in the Auto Industry?

A fresh new set of auto sales data has come out in the beginning of August detailing the past month's activity in the buying and selling of motor vehicles. As expected, auto stocks traded lower when the disappointing results were revealed. According to Reuters, shares of General Motor (GM), Fiat Chrysler (FCHA), and Ford (F) traded more that 3 percent lower last week. Reports of March light vehicle sales at about 16.6 million where analyst expectations had drifted slightly above 17 million. Since the financial crisis, automakers have enjoyed a steep expansion in auto sales, but in the past couple of months, that expansion has stopped.

Data from Quantopian and Bureau of Economic Analysis
In 2011, a global auto industry exchange traded fund (CARZ) was created to follow the price movement of some of the largest automobile companies in the world. GM and Ford account for over 15 percent of the fund's holdings with Toyota and Honda (both of which rely on U.S. demand) making the ETF very sensitive to auto sales in the United States. After its birth in 2011, CARZ saw a steep incline in its price as light vehicle sales grew steadily. As demand in the industry started to show some slack, the price dipped in 2015 and early 2016. The current dive in auto consumption has CARZ down about 4.7 percent in the last 20 trading days.

With sales starting to slow, there has been an incline in inventory that has left the U.S. auto suppliers in a pickle. Overall, production and imports of cars need to be falling to keep the industry in equilibrium in order to maintain a stable price. Domestic production, in the past 12 months, has fallen just over 14.3 percent while the declines in imports from Canada and Mexico are less significant (and very volatile). This conveys an interesting political signal that suggests Trump's domestic manufacturing goals. After demanding U.S. auto companies to move their manufacturing bases inside the country in his first days as the President, these initial data suggest his protests have been futile. Another interesting observation is to note that inventories haven't seen as significant a move as U.S. production has in the last two years. In fact, inventories have always oscillated within 2.0 and 3.0 with only the latest data peaking about 3.0. The abrupt change in inventories could be a drag on prices which, combined with falling sales, could weigh heavily on automakers' bottom lines.

Data from Bureau of Labor Statistics

From the Bureau of Labor Statistics, consumer price index (CPI) data for automobiles, both used and new can be viewed over the past ten years. The CPI for both used and new vehicles has stayed relatively flat from 2012 to now after recovering from a dip caused by a lapse in demand during the financial crisis. For new and used vehicles, prices recovered above their pre-crisis levels in 2010 with more volatility in used car prices. In fact, it seems as if the most of the fluctuations in the overall auto CPI are caused by movement in used CPI. According to this data, automakers selling new cars have enjoyed stable, increasing prices with used car prices inflated beyond their 2007 levels. Perhaps, over the past six years, this phenomenon led consumers to believe that purchasing a new car over a used car was the smarter decision. Thinking practically, used car demand growth post-crisis makes sense because consumers who needed a vehicle might not have had the discretionary funding to purchase an entirely new car. But as demand strengthened, prices rose, and consumers calmed, new auto sales grew. It is possible that now we are observing demand for the "cheaper" used autos grow replacing demand for new autos. This might explain why U.S. production has trailed off while inventories have continued to rise. It is also interesting to note that, according to Reuters, consumer discounts were $441 higher per vehicle than a year ago, a sign that companies were trying to compete with cheaper used cars on the market.

Post-crisis, an interesting trend in used car CPI and light vehicle sales data can be identified. Using data from 2010 on, one can observe a strong negative correlation between used car CPI and new light vehicle sales as reported by the Bureau of Labor Statistics. With a correlation coefficient of -0.73 and a statistically significant p-value, the data suggests that as used cars get more expensive relative to new cars (signaling heavier demand) new light vehicle sales are smaller. When CPI growth for used cars decreases relative to new car CPI growth, sales are likely to be higher for new vehicles. As far as timing goes, the current trends suggest that auto sales lead normalized used car CPI slightly as it troughed about a year and a half before used car CPI peaked.

Some interesting regressions suggest that a strong negative correlation exists between used car CPI and the monthly price of CarMax. A weaker negative regression can be found between used car CPI and Ford's stock price. This may suggest that KMX stock price moves more strongly with used car CPI changes than the rest of the auto industry, but this conclusion may be all. Due to the reflation of the post-crisis economy, any correlation with a growing stock price can be a bit skewed. In the end, these two statistical connections are probably not significant despite having low p-values.

This article was written using Quantopian's IPython platform. The Python code can be downloaded here: .py .ipynb

Saturday, April 8, 2017

The Federal Reserve Decides to Diet

In a press conference on April 5th, 2017, Federal Reserve officials announced their desire to start reducing the size of the Federal Reserve's balance sheet this year. Since the financial crisis in 2008, the size balance sheet has grown to $4.5 trillion worth of bonds and other assets bought up during the period of quantitative easing following the crash of the financial system. In the latest Fed minutes voiced this idea saying, "Provided that the economy continued to perform about as expected, most participants anticipated that gradual increases in the federal funds rate would continue and judged that a change to the Committee's reinvestment policy would likely be appropriate later this year." Since 2009, the members of the Federal Reserve have used various techniques to maintain loose policy as the economy reflated. Lately, though, these mouthpieces have been used to institute a "normalization" policy that will allow interest rates to rise while keeping intentions expansionary.

from Federal Reserve
In 2007, arguably the last year of the period called "The Great Moderation," the Federal Reserve's balance sheet was below $1 trillion and consisted of mostly Treasury assets used to manipulate interest rates through open market operations. As the crisis unfolded, Fed Chairman Ben Bernanke and Treasury Secretary Hank Paulson saw it necessary for the United States' central bank to buy up the assets that had become worthless due to mortgage defaults. This unconventional intervention in the financial markets, called "quantitative easing," slowed to a stop in the early 2010's, but by then, the balance sheet had more than tripled. The average increase per year over the past 10 years was about 25 percent.

The chart above shows different asset classes within the Fed's balance sheet accounting for general securities, securities purchased through liquid facilities, and securities purchased to support specific institutions. Growth in the last two was only significant during the financial crisis and was quickly wound down when financial markets return to normal. The assets from credit facilities included purchases by the Term Action Credit, Commercial Paper Funding, Central Bank Liquidity Swaps, and Term Asset-Backed Securities Loan programs. These "liquid facilities" were put in place to create demand in the markets for mortgage-backed securities (MBS), commercial paper (CP), and currency, in particular, the dollar. Even though these programs have been largely inactive since 2010, they ushered in a long period of quantitative easing.

Looking closer at the 3 year period around the financial crisis reveals a jump in the activity of the liquid facilities that spurred the growth of the Federal Reserve's balance sheet. Two of these programs saw activity before the fall of Lehman Bros in late 2008, the Term Auction Credit (TAF) program and Central Bank Liquidity Swaps. These credit facilities are no longer being used and haven't been since around 2011, but some of the assets still linger on the balance sheet. Most of those assets are loans supplied by these programs (mostly Term Asset-Backed Securities Loan Facility) in which credit facilities were provided for banks with the MBS put up as collateral.

Unwinding a balance sheet of an assortment of $4.5 trillion assets is a very complicated process. With such careful decisions being made about interest rate hikes, the Federal Reserve has shown how important they think timing is in monetary policy. Their stance will be no different this time around. In an article from the Brookings Institute, Ben Bernanke refers to the Fed's most recent discussion of how to unwind the balance sheet released in September 2014 suggesting that, "the balance sheet will ultimately be reduced, not by sales of assets that the Fed holds, but by ceasing or phasing out the Fed’s current practice of replacing or rolling over maturing assets (“reinvestment”)." This makes sense. Federal Chairwoman Janet Yellen has assured us that she doesn't intend to shock the markets with what her board does, and so far, she has not disappointed. With that in mind, investors shouldn't be expecting a smaller Fed for a while. In fact, the process may end up being a non-issue with conventional monetary policy changes always occupying the spotlight. The Federal Reserve hasn't actually decided on how to go about the unwinding yet, but investors can expect a very tame approach in the end.

During the press conference in April, the stock market saw a reversal in the day's trading reflecting a bearish response to the unwinding balance sheet. Although the process will be gradual, there will still be fundamental adjustments in financial markets. Investors can expect most of these adjustments to be made in the bond and short-term lending markets with equities being less affected. If anything, the effects of an unwinding balance sheet will be harmonious with the Fed's plan of slowly increasing interest rates, both long and short term.

from Quantopian

The correlation between the growth in the Federal Reserve's balance sheet and the performance of both long and short term Treasury and corporate bonds is quite strong. Using SHY (Short-term Treasuries), IEF (Long-term Treasuries), CSJ (Short-term corporate), and CLY (Long-term corporate) price trends, a connection can be made between the return of these exchange traded funds and the expansion of the Federal Reserve's balance sheet. With correlation coefficients above 0.80, a strong positive correlation is confirmed at a statistically significant level. The corporate bond ETFs saw correlations that were a bit stronger with the correlation coefficient of CSJ, the fund following short-term corporate bonds, recording an R-squared value of 0.93. From this analysis, one can expect these funds to underperform when the Federal Reserve begins the unwinding process. As interest rates and bond yields start to rise, prices will fall, and this trend will be accelerated with the Federal Reserve reducing demand in those markets. With the speech having reintroduced the issue, market expectations should start to affect the changes in the bond market, and a reaction will be evident soon enough.

The article and charts were written in Python in an IPython Notebook. You can download the code here: .py .ipynb