Stalling again

Mar 18th 2005
From The Economist Global Agenda

General Motors' latest profits warning is terrible news for the giant carmaker. Is it also terrible news for the credit markets?

AT THE start of March, when General Motors (GM) announced sales figures for February, it was similar to the sound of a car badly misfiring—a sure sign that something was amiss under the bonnet. In America, the giant carmaker's vital home market, GM's vehicle sales had slipped by 12.6% compared with the year before and its market share had collapsed by a staggering three percentage points, to just over 24%. This week, when GM gave warning that it expected a loss in the first quarter of 2005 of some $850m, it was the financial equivalent of smoke pouring from the engine bay—something needs fixing, and fast, if GM is to preserve its position as the world’s largest carmaker and avoid the downgrade of its mountain of debt to junk status. Yet so far, Rick Wagoner, GM’s chief executive, has resisted calls to revise his faltering strategy.

Most carmakers in America are feeling the pinch. Total light-vehicle sales fell by 1.8%, to 1.25m units, in February 2005 compared with the same period the year before. But not all carmakers have suffered equally. While Ford and Honda, like GM, endured declining sales, competitors have prospered. DaimlerChrysler, Nissan and Toyota all enjoyed growing sales last month.

Because of its poor performance, GM has been forced to cut production in North America by some 10% for the first half of the year (around 300,000 cars). Buyers have reacted less than enthusiastically to the Detroit giant’s new vehicles of late. And the firm, which led the way in boosting the recovery of America’s car industry with a series of discounts and incentives in the wake of the September 11th attacks, has had to resort to yet more inducements to persuade consumers to buy its motors. GM is banking on a better reception for a range of light trucks and sport-utility vehicles set for launch this year and next.

It does not help that GM is saddled with a highly unionised workforce that is correspondingly well paid compared with non-unionised Japanese competitors. And it faces mounting “legacy” costs from the health-care and pension plans it has provided for its employees; its health-care costs alone are expected to rise by $1 billion this year. Other costs are mounting too. World steel prices are soaring along with those of other raw materials. And the high oil price is likely to have an impact on car sales, or at least persuade buyers to choose smaller vehicles, where profit margins tend to be lower.

No wonder, then, that GM, which had been expecting to add $2 billion to its cash position this year, is now forecasting a $2 billion depletion. And that excludes the costs of a recent settlement with Fiat (in which GM agreed to pay the Italian carmaker $2 billion to cancel a put option) or the restructuring of GM's European arm, Opel (12,000 jobs to go).

Credit crash ahead?

Whenever GM blows a gasket, the credit markets sputter too. That is because GM is a giant not only in carmaking but also in debt issuance. It is America's third-largest issuer of corporate IOUs, with a little over $300 billion outstanding. Some even see the company as a bellwether for the credit cycle.

Hence the concern over the financial impact of GM's profits warning. The spread (risk premium over Treasuries) on the firm's bonds rose by an unusually large 53 basis points (hundredths of a percentage point) on the day. The rating agencies were quick to react. Fitch downgraded GM to BBB-, only one notch above junk. Standard & Poor's, which also rates the company's debt as barely investment grade, signalled that it was considering a downgrade. Moody's may do the same, though from a slightly higher level.

By some measures, GM's debt is already junk in all but name: the spread on its bonds is now higher than the average spread in the main index for high-yield corporate bonds. All the same, an official downgrade to junk would greatly compound the firm's misery. Many institutional investors are required to hold only investment-grade paper, and would thus be obliged to dump GM's bonds, lowering their price and raising the firm's financing costs.

Might GM's woes mark a turning-point for the credit cycle? In recent months, spreads on corporate debt of all stripes have been near record lows. In the investment-grade market, the average yield over Treasuries fell by more than 150 basis points between the beginning of 2003 and GM's profits warning, according to Moody's. Not surprisingly, investors are getting increasingly nervous that they are not being rewarded properly for the risks they are taking.

With spreads so tight, there is barely any room for error.

GM alone is unlikely to tip the credit markets. Bond investors, after all, spend more time worrying about inflation and interest rates than they do about any single borrower. But GM's failure to shift enough cars and trucks may end up hurting more than the company itself.

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