Soaring Used Car Prices Drop A Bomb On Bulls’ Fed Pivot Hopes

Houston, we have a problem! The rate of core inflation had pulled back off of summer 2022 highs, helped in large part by an unwinding in the massive pandemic used car bubble. But now, fed-up consumers are racing to buy used cars, so prices are back on a rapid ascent. This calls into question the entire disinflation narrative.

The dumpster-fire market for used cars was perhaps one of the clearest indicators of an unhealthy, unsustainable economy during COVID. In some ways, it was a perfect storm. Congress flooded the system with stimulus money at the same time that semiconductor shortages punished auto manufacturers. By the summer of 2022, things had started to normalize. By fall, bulls had rightly taken the popping of the used car bubble as a marker of a slow return to a normal economy. Wholesale used car prices (standardized for make, model, and age/mileage) peaked in January 2022 at about 258 index points and fell to 218 by November 2022. But now, they’re back up to 234. Before the pandemic, prices were about 156, or 33% lower than they are right now. Used car prices are going up again, and they’re going up at a historically fast rate not seen since 2009, according to Manheim’s data.

This hasn’t shown up yet in the CPI reports because of the lag in reporting, but it’s about to. AutoNation (AN) is America’s biggest car dealer. Helpfully for us, AutoNation just reported earnings, and they said their margins were about flat at near-record highs. With this piece of info in our pocket, we can be pretty sure that rising wholesale prices aren’t being eaten by dealers via lower profit margins. Instead, inflation in goods is likely back, and back in a big way.

Sluggish Real Wages Are Being Loaded Down With Debt

Here we see median weekly earnings. In February 2020 the median was about $983, and now it’s about $1146. That’s roughly a 5.3% increase per year. But when you adjust it for overall inflation, you get this.

This isn’t a disaster, but we’re obviously below our previous trend. Weird stuff happened in early COVID– the spike was from lower-wage service workers disproportionately getting laid off and from companies offering higher pay for those willing to risk COVID exposure.

So we know that both typical wages and prices are up about 16% since pre-pandemic, but what about the price of homes and cars? Well, cars are up 33% and rising since the pandemic, which is double the gain in wages. Homes are up about 43%, nearly triple the rise in wages.

It gets worse– to stop inflation from spiraling out of control, the Fed has been forced to rapidly hike interest rates. So not only are homes and cars 30-45% more expensive, but it’ll now cost you 5-6% for a car loan and about 7% for a mortgage– about double the going interest rate before. So a $30,000 used car that might have been financed @ 3% will now cost you $40,000 @ 6%. Thus, the typical car payment or mortgage is up even more than the raw rise in prices would imply.

We shouldn’t ignore the effect of chip shortages on car production, but total sales over the full period of the pandemic were about in line with the mid-2010s. Courtesy of massive stimulus and FOMO, this looks a little more like a demand issue and a little less of a supply issue than the mainstream media is giving it credit for.

What’s going on now? Prices are charging higher again in 2023. In large part, this is due to mass psychology. Fear of shortages and a lack of credibility at all levels of government have fundamentally changed consumers’ thinking. Moreover, the collective experience of going through a pandemic has shifted consumer psychology to emphasize the short term over the long run (YOLO) and to avoid the fear of missing out (FOMO).

If wages are up about 16% since pre-COVID, then how are these big bubbles in housing and durable goods occurring? Easy answer– first with stimulus and now on credit. It’s one thing to pay big prices for eggs or milk out of pocket. It’s an entirely different thing to pay $799 a month for a used car for 72 months, as financing makes it easier to overpay. This is the reason that houses and cars are vulnerable to price bubbles in ways that typical goods and services aren’t.

It’s the responsibility of the Fed here to shut down speculative borrowing by consumers and businesses unless we want to invite the risk of another 2008-style financial crisis. Used cars are a problem for the Fed because they’re a symptom of an out-of-control speculative economy where prices soar, wages stay stagnant, and the difference is borrowed. Savings rates are near-record lows, while credit balances are soaring. Market-based expectations for inflation are rising again as well.

There’s a 100% chance of this causing problems at some point in the future. It might be sooner or it might be later, but this will come home to roost. It’s one thing to say that the national savings rate is about 3% (with no one paying student loans), but it’s another to understand how savings rates differ by level of income.

This is a chart from a well-known economics paper from about 25 years ago called “Do The Rich Save More?). These numbers were from a typical economy (late 1990s) where consumers save an average of 7-10% of their income.

The key insight here is that the average savings rate doesn’t mean much in a vacuum, but low savings rates tell you a lot about the vulnerability of the overall economy. In a typical economy, those under about $40,000 in household income tend to spend a bit more than they earn, those who make under $100,000 tend to save modestly (~10% of after-tax income), and by the time you get over $500,000, savings rates tend to rise substantially, especially if the high incomes are being driven by annual bonuses or capital gains.

However, the crazy economy we’re in has shifted things to the point where perhaps the bottom 80% of income earners are spending more than they’re making, and the top 20% aren’t saving much either. As a result, prices keep surging while wages stay relatively steady. The difference is simply put on credit. Inflation is eating America’s savings alive and shifting consumer thinking from the long-term to the short-term. And the longer savings rates remain near record lows, the more dominoes will fall during the eventual recession. The seeds for future economic damage are already sown, and thus the main challenge for the Fed at this point is minimizing it.

What Does This Mean For The Fed?

January CPI showed a 1.9% decrease in the price of used cars, which we can infer is the stale used car prices still coming through. As measured by CPI, retail used car prices are due to rise in the coming months, possibly by a lot. As a ballpark figure, used cars are about 4% of core CPI, so a 2% increase in used car prices would swing core CPI by about 16 bps for the month. Core CPI came in at 0.4% for January (4.9% annualized), which was already pretty hot, so this could crank it up to 0.6% (7.4% annualized). One or more months of 0.6% monthly core CPI prints would tell the Fed that they’re again behind the curve, and force them to raise rates even higher than thought.

Only three weeks ago, the market went all-in betting on a Fed pivot, and Powell folded his cards at the river. Stocks printed their 2023 highs shortly after. Now, with the stock market setting up another showdown with the Fed, the odds are increasing that they’ll get caught bluffing. The market has more or less continuously lost to the Fed since the first hike in March 2022, with each low being lower than the last. This time around, however, the bond market is unwilling to challenge the Fed, with 10-year Treasury rates up about 50 bps since the previous meeting, and the dollar stronger. The stock market is going this one alone.

A recent Seeking Alpha piece by Mott Capital shows that the Fed funds market is also starting to price in reality (“starting” being the key word here). And of course, there is certainly the potential for Fed minutes this week to tell a more hawkish story than bulls would like to hear. With stocks trading near peak multiples and still priced for a rosy return to low rates and low inflation, another February CPI upside surprise could set the stage for one or more 50 bps hikes in the Fed funds rate–on the way to rates of 6% or higher in short order. Retail stock traders aren’t getting the message, and are pouring record amounts of money into meme stocks. But if the Fed wants to crack down and stop consumers from spending money they don’t have, they’re well equipped to do so. That might mean the risk of taking cash rates to near 7% and mortgages to near 9% to shut down consumers who insist on spending at unsustainable levels. If this comes to fruition, investors will rue the day they paid nearly 20x peak earnings for the S&P 500 (SPY).

In the end, like a fall from a high place, the longer there is “no landing,” the harder the eventual landing will be for high multiple stocks and pivot-hungry bulls.