European Automakers – Trade War Woes Add Pressure on Bonds

Trade war fears have dominated the headlines recently, but European automakers already face other serious headwinds. We believe bond investors should tread warily in this sector.

Potential Tariffs a Serious Threat

Leading European auto manufacturers are getting caught in the crosshairs of global trade wars. Concerns have mounted that the US might slap a permanent tariff on EU-produced autos. Although we see this as a low probability, it would have a serious adverse impact on European carmakers. In our view, Aston Martin and Jaguar Land Rover could be hit hardest, because they have no production facilities located in the US, one of their key markets. But we believe US tariffs could severely shrink the cash flows of the larger EU manufacturers too.

Potential US tariffs on Mexico are a further threat. This is another low-probability but potentially damaging scenario, as all German carmakers have assembly plants in Mexico that ship vehicles to the US. In fact, BMW just opened its first plant in Mexico on June 6 this year. We expect tariff risks will remain elevated while President Trump is in office. This unpredictability in trade policy is a problem for all companies that have a global manufacturing footprint, but the auto industry is amongst the most seriously impacted.

Meanwhile, risks have been mounting in several other directions. Credit spreads of the main auto companies have recently narrowed, after widening earlier in the year, which warrants caution. Leading European carmakers will likely continue to face negative fundamental headlines on a variety of cyclical and secular issues.

• Onerous European Emission Regulations—Regulations on emissions in Europe will tighten considerably in 2020/2021, which will be a drag on profitability owing to added content and an adverse mix of hybrids/electrics. There is considerable uncertainty about the customer’s willingness to pay for vehicles with lower emissions and/or better fuel economy. Longer term, the outlook will become even more challenging as the European Union recently passed legislation to further reduce emissions in 2025 and 2030. We are concerned that governments will not provide enough carrots or sticks to encourage the necessary customer adoption.
• Weak China Demand—Demand in China this year has disappointed and does not appear to be rebounding any time soon. Premium brands are performing better than the mass market, but the lack of return to previous volumes is a concern.
• Bond Issuance Will Stay Heavy—Most major carmakers own captive finance companies that rely on the capital markets for funding. Much of the funding is in relatively short-term unsecured bonds, with average maturities of three years. This results in substantial funding needs each year. Over the medium term, issuance will likely increase. We expect the finance company balance sheets to grow as each of the carmakers look to use their captives to help drive adoption of hybrid and electric vehicles through expanded lease offerings.
• Late Cycle Fears—With volumes having peaked in the US and Europe, there is concern that we are late in the cycle for auto sales and susceptible to a broader downturn. While our base case is for a gradual reduction in volumes over the next few years, we are worried that an economic shock could cause a sharper-than-expected deterioration in sales and margin contraction.

Bearing these combined negatives in mind, and with bond valuations having improved, we do not see much room for further spread tightening. And with the potential for serious trade war downside, we think the risks for fixed-income investors in the sector have increased significantly.

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