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Recession concerns and interest rates are ‘lethal combination’ for vehicle demand: Economist

Cox Automotive Chief Economist Jonathan Smoke examines how trends in gas prices and declining car dealership sentiments are impacting car markets, while also commenting on Carvana and car demand heading into 2023.

Video Transcript

SEANA SMITH: Good news for Americans. US gas prices lower than they were a year ago. The average cost of a gallon of gasoline today is $3.33. That's according to AAA, a penny below where it was one year ago and far below the record highs that we saw over the summer when gas cost over 5 bucks a gallon. The drop in gas coming as crude falls to its lowest level of the year, settling today below 72 bucks a barrel. Well, the price declines, though, have not extended as much to diesel. The current average sits at 5 bucks a gallon, much higher than last year's average of $3.61.

Yahoo Finance, earlier this week, conducting a poll asking how gas prices are affecting your spending, whether or not they're causing you financial hardship. The majority of voters saying yes, despite the drop in gas prices, with 54% saying it is causing them financial hardship.

DAVE BRIGGS: High demand plus low supply equals good times for car dealers across the country in the last few years. But those times are a'changing. Cox Automotive latest Dealer Sentiment Index came in at its lowest level since the start of the COVID-19 pandemic. The current mark? 43. It sits well below the ideal threshold of 50 and indicates the majority of dealers view the market as weak.

Joining us now to discuss the outlook is Jonathan Smoke, Cox Automotive chief economist. Good to see you, sir. So why are car dealers across the country viewing this market as weak?

JONATHAN SMOKE: Well, as you pointed out, what a difference a year makes because we basically have enjoyed two of the most profitable years in dealers' history. But now we're facing the prospect of a recession, along with interest rates that are now at 20+ year highs. And that's a lethal combination for vehicle demand. And basically, dealers are feeling it.

SEANA SMITH: How much does limited inventory still play a factor? And I guess, when you compare what we're seeing this month to what we've seen more historic-- the historic norms, I should say, how does that compare?

JONATHAN SMOKE: It still plays a role. But inventory has gone from being the number one problem a year ago to now number three, solidly behind the economy and interest rates. We are seeing the new vehicle inventory situation, which is really where the scarcity has been dramatically changed in roughly the last four months. We crossed 1.5 million in early November, which is up about 40% over that time frame.

But we normally have over 3 million units on lots this time of year. So it's moving in the right direction. And I would characterize that what's happening right now, when you combine it with affordability being a challenge with interest rates, is, what is gaining in the new vehicle market is actually deteriorating the conditions in the used vehicle market because used has been abnormally strong because of people who would normally buy new, having to buy used.

And now those folks are able to go back in the new market, leaving behind dependence on the traditional used car buyer. And those are the very people that are the most rate sensitive and not able to buy at today's prices.

DAVE BRIGGS: I know you don't want to comment on a direct company, but are those basically the ingredients that have led to what we've seen with Carvana?

JONATHAN SMOKE: It absolutely is connected. The used car market has been deteriorating all year. We are on track for ending the year down 11% or 12%, depending on how December goes. And basically, we've really seen strong deterioration once interest rates started to move. And so it's really been late spring.

And as the year progressed and we do our surveys that you mentioned, heading into this, was-- have basically shown all year that independent dealers, which, technically, Carvana is considered one because they don't sell new vehicles and are not a franchise dealer, they have been negative about the market since the very beginning of the year and growing more pessimistic as the year progressed.

DAVE BRIGGS: So what could be a catalyst here for changing this dynamic, Jonathan?

JONATHAN SMOKE: Well, I think we've got to, one, hopefully thread the needle and see a soft landing, although we see that prospect as roughly a toin cost-- a coin toss right now, in terms of what could take place. One of the things will sort of resolve itself. We think we are in for basically another six to eight months of the significant above average depreciation we're seeing in used vehicles.

And that's the good news story. When interest rates finally reach their peak and we see used car values down another 10% to 15%, especially on the retail side, which has lagged behind, that opens up affordability opportunities for the consumers who've been pushed out of the market. And used typically does well in a recession because prices correct, and when prices are better, consumers who've been priced out of the market are more likely to be able to purchase.

SEANA SMITH: Jonathan, what about buyer incentives that largely were sidelined during COVID because of the strong demand that we had seen for a couple of years? Is that going to return?

JONATHAN SMOKE: It will return when the supply gets substantially bigger, and we're not there yet. We've basically seen incentive spending on the new vehicle side increase a little bit less than 3% in November. But incentives relative to the average transaction price, which is the real measure, remained at a historic low of 2.3% in November.

So basically, manufacturers are not having to put money into it. Historically, that number has been closer to 10%. So it's a dramatic difference in terms of the low level of incentives that are out there. And I really think we're going to have to see inventories build by probably 50% more, if not 100% more, from where we are to really see those conditions change.

SEANA SMITH: So we've got a ways to go. All right, Jonathan Smoke, Cox Automotive chief economist, thanks so much for joining us.