Automobile Industry

Before an analysis of potential stocks for a portfolio can be undertaken, one must first analyze the environment in which the respective companies conduct their business. First, I want to elaborate on the state of the economy as a whole before I will focus specifically on the automobile industry and its particular role within the American economy at present.

Economic Analysis

The American economy is entering 1998 in its 8th year of economic expansion. Surprisingly, a real downward trend is not in sight; to the contrary, the prospects for the economy are still very promising. The numbers are impressing, considering how long the economic upturn has been: e.g. the inflation rate is stable at 1.7%, unemployment is at its lowest level in over 20 years (4.7%), and the consumer confidence in the economy is still very high.

The near future also looks rosy: producers' durable equipment spending is expected to rise by 10%, indicating that the economy is still anticipating an upward trend. In fact, industrial production is expected to rise at a rate of 4.2% for 1998. GDP growth is expected to lie between 2.5 and 2.8% for '98 only a moderate decline from 1997's over 3%. The same goes for the unemployment rate, which is projected to remain fairly stable at 4.7-4.8 %.

As far as interest rates and inflation are concerned, 1998 looks very promising: A moderate increase in the CPI to roughly 1.9% is expected, a very low figure, considering the late stage of economic growth. Some experts believe the rate of inflation might rise as much as 4% over the year, though. They expect a continuing rise in wage levels, which already rose by 3-5% over the last few months. As these higher compensation costs are usually passed along in the form of higher prices, there is a slight threat of beginning cost-push inflation in the year's ahead.

But as the economy is expected to slow down late in the year, the pressure on the inflation rate will most likely not be too immense. Given the expected moderate increase in inflation, the Federal Reserve Board will probably refrain from raising interest rates, especially given the difficult situation in Asia and the impact on American companies. Important export markets such as Japan, the U.S.'s 2nd largest trading partner, and Korea are on the brink of a major recession. Other markets such as Thailand, Indonesia or Brazil also expect an economic standstill, largely due to their recent currency problems. These dark outlooks will have a direct impact on American exports, which will most likely suffer and slow down U.S. economic growth.

Under these circumstances the Fed might even consider lowering the interest rates, but at least keep them stable to keep the economic "engine" running. As inflation rates tend to be very high as the economy reaches its upper turning point, and given the positive outlook, I suspect that the U.S. economy should see another 1.5 - 2 years of continuing upward trend before it turns down.

I believe we are now slowly approaching the top of the business cycle - the expansion period should come to an end pretty soon. I don't think this will occur in 1998; the indicators still look very promising for this year. On the other hand, 1999 might experience sharp increases in interest, inflation, and unemployment indicating that the economy is overheated and about to turn down.

Industry Analysis

The automobile industry is a highly cyclical one, i.e. an economic boom is generally accompanied by high sales in the automobile industry, while sales usually suffer during economic downturns (let alone recessions). The correlation between sales of the industry and GDP is extremely high. The strength of the economy is, by far, the major determinant of auto company sales and profits. Sales are similarly tied to the level of consumer confidence and to people's spending power. This is due to the usually high investment involved with the purchase of a new vehicle. During a prosperous time with high incomes, many families and individuals have the means to buy a car, whereas they try to save their money when times are not so rosy and avoid such a large expense.

As I pointed out we should see another 1 1/2 years or so with a healthy domestic economy, aiding auto sales for that time. This might be offset by reduced exports to the Asian region, though. Therefore I would suggest that production and sales figures remain largely at the current level. After about two years, I would then expect contracting sales in the industry in accordance with a general downturn in the U.S. economy. Consumer spending is going to go down and the outlook of a coming recession will keep many buyers out of the market, who want to prepare for the bad times ahead.

Characteristics of the Automobile Industry

Although I will deal with specific characteristics of the industry in the next section using Porter's competitive strategy model, I would like to provide some general information about the auto industry at this point.

The industry is characterized by a high degree of operating leverage, i.e. most of its costs are of a fixed nature. Compounding this feature, the labor contracts of U.S. companies tend to guarantee the income of a worker, even if he or she is laid off. This converts what would normally be a variable cost into a fixed one. To be profitable, the manufacturers need to sell at high volumes and must keep the plants running as much time of the day, as possible.

Even though production technology in the auto industry has increased a lot over the years, the auto industry is still a labor intensive one. Ford employs over 370,000 people and GM even 650,000! This keeps costs at a very high level. Companies have tried to cut the size of their work force over the past years to stay competitive and encountered stiff resistance from labor unions, particularly the United Auto Workers (UAW). UAW-organized strikes at GM plants cost the company production of 96,000 vehicles in the 2nd quarter of '97 alone; Chrysler reported similar losses. It can be expected that the cost burden on auto-makers will not decrease over the short run, which heats up competition even more.

Finally, the U.S. automobile industry has seen some interesting developments in the last few years. Demand has been gradually shifting away from cars to light trucks. These include pickup trucks and the increasingly popular minivans and Sport Utility Vehicles (SUV). In fact, car sales have steadily declined in the last few years, while truck sales have experienced healthy growth. Of the roughly 15.2 million vehicles sold in the