Inside the numbers: Supply, demand and off-lease volume


Your credit is good and the lease contract on your 2015 vehicle is about to expire: what are your options? You could choose to pay the residual and keep your current ride. You could trade the vehicle for a new one or for an alternative used car. Finally, you could hand in the keys and wait for the bus to take you back home.

When thinking about the effect of the ongoing surge in off-lease volume, it is important to keep these options firmly at the front of mind. Market participants are right to fret about the possible effects of off-lease volume, but not for the reasons usually put forward. Returning an off-lease vehicle certainly causes an increase in supply but, usually, it also generates demand for a replacement vehicle.

Determining the manner in which these forces balance is not a straightforward exercise. One could argue that if the customer leaves with a higher valued vehicle, there has been a net increase in demand because of the transaction. Yesterday the customer was happy driving a $10,000 car. Today they are driving a $20,000 car, therefore they have demanded “more” car. If the client leaves on foot, or in a lower valued vehicle, the net result is an increasing supply to the market. Most commentators, when considering the ongoing surge in off-lease volume, ignore this complexity, recognizing the car entering the lot but ignoring the one that leaves.

The other point is that the distinction between the new and used markets for cars, at least on the demand side, is a fine one indeed. The last time I bought a car, I entered the dealership determined to buy a used Jeep Wrangler. That I drove away in a brand new one suggests either that relative prices were favorable or the sales person was very good at their job. If a sucker, like myself, is enticed to switch to a new car, the used car market does not really suffer. There exists only a market for cars, and players in this space would, frankly, rather sell you an expensive new one than a cheaper old one. If someone swaps their used off-lease vehicle for a new one, this transaction is a positive outcome for all players in the auto industry.

Tony Hughes, Moody's Analytics

In reality, only three factors unambiguously affect the overall supply of cars in the economy and hence the prices we expect for cars for a given level of demand. The factors are domestic new production, net imports of new and used vehicles, and the rate at which older vehicles are retired from service.

The first two of these factors are easy to quantify using readily available statistics. Compiling data from various trade sources, we find that real net vehicle imports grew by 20.4 percent in 2015 before slowing to 5.8 percent in 2016. Domestic production, meanwhile, continued its slow secular decline that began immediately after the recovery from the Great Recession. The number of cars manufactured in the U.S. fell by 2.1 percent in 2015 and by 5.9 percent last year. These figures should be viewed in the context of consecutive record new vehicle sales numbers over the past two years. If we assume that imports and home-grown cars are roughly equally prevalent, we find that there was a surge in vehicle supply in 2015. This surge was driven primarily by a climbing greenback, but 2016 was basically a wash.

New vehicle manufacturers from around the world might be tempted by the surge in off-lease volume to increase production relative to baseline. People returning three year old leased cars, after all, have recently demonstrated a willingness and an ability to drive a new car away from a dealership. Carmakers know that these people are prime prospects because they need wheels the moment the keys are returned. If this sales strategy is unsuccessful, which happens if non-traditional lessees return to used car ownership, we might be left with a glut of cars in the marketplace that are too new for the prevailing market.

At the other end of the spectrum, a consideration of old car retirement is also needed. We recently conducted a deep-dive on the nature of U.S. passenger vehicles by considering the most recent Consumer Expenditure Survey, conducted in 2015. Respondents were asked about the vehicles they owned and model years were recorded. We can use these data to determine, with some precision, the age profile of the U.S. vehicle fleet.

In 2008, on the eve of the Great Recession, 42 percent of vehicles owned by Americans were ten or more years old. By 2015, in contrast, a full 52 percent of vehicles had been around for a decade or more. The aging fleet is partly due to ongoing improvements in production standards. The numbers also suggest, though, that there are lots of clapped out cars on the road that are due to be retired. By our calculations, the number of vehicles entering retirement each year grows by 25 percent between 2013 and the high-water mark that arrives in 2019. This high rate of vehicle retirement represents a reduction in supply that helps to cushion any increase in production at the new end of the pipeline.

The other startling feature is the dearth of autos in the 5- to 9-year-old range — vehicles that were introduced to the market during the depths of the recession. In 2008, 34.6 percent of cars fell in this band but had fallen to only 24.6 percent by 2015. If lessors are currently feeling the heat, it is nothing compared to the inferno they will face if they are currently originating large volumes of three-year leases. The rate of vehicle retirements plummets in 2020 as the thin cohorts hit peak retirement age. This inevitable process yanks away the cushion from the vehicle supply chain.

To summarize, we currently have lots of new cars, lots of old cars, and very few middle aged cars in the national fleet. This situation leads to some interesting dynamics in the pricing of automobiles. For one thing, the prevalence of lightly used cars means that new vehicle manufacturers have very little pricing power. We have seen new vehicle sales fall markedly this year, and generous incentives have been offered to move stock.

We have also seen significant compression in used car prices. This can be seen, for example, in the average of all wholesale transactions for 0-3 year old vehicles from the NADA database. Our analysis shows that prices of light trucks have fallen by 3 percent since their peak value in 2011, while car prices have declined by a full 13 percent. In contrast, 4- to 6-year old cars have fallen by only 4 percent while older trucks have surged higher by 10 percent. In other words, relative discounts one might expect when purchasing an older vehicle have declined considerably. People who are in the market for a 5-year old car are finding that they can get a 3-year old version without spending much more money.

So, where does all this analysis leave us? It is the combination of too much production and insufficient demand for new vehicles that is depressing newer car prices. It is not that there are too many cars in the market alone. Production (which includes imports) has shown signs of slowing, suggesting that manufacturers have worked to curtail the emergent glut of new cars.

Financial interests are far more exposed to prices of new and slightly used cars than they are to prices of older cars and clunkers. Markets are therefore watching the auto industry closely for signs of strain.

When thinking about car prices, close attention should be paid to the nature of vehicles being driven; the manner of their financing is rather less consequential.

Tony Hughes is a managing director at Moody’s Analytics, where he leads the development of used-car price forecasts. Hughes also conducted a webinar about this topic with AuSM earlier this year that’s available here.