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Zero percent on; zero percent off. The unprecedented incentive deals offered since October, 2001, have contributed to a burst of vehicle sales that heretofore would have seemed most unlikely given the slow economy and rising unemployment. Strong sales this year have been a surprise to every industry pundit we know. If predicting 2002 was this tough, how should we look at 2003?

Vehicle pricing is arguably the most important input in determining the demand for autos. If you want to forecast auto and truck sales over the next 12 months or so, you first need to make an assumption as to the level of vehicle pricing. The auto industry of late, however, has made car and truck pricing more complicated, which, in turn, has added uncertainty to the job of forecasting vehicle sales.

Since last October, many consumers seem to have focused on "0% financing" largely ignoring other components of the pricing equation. Automakers, for example, have been shuffling the content of their vehicle offerings, often "de-contenting" or removing features previously offered within a basic package price. For the same price, the consumer sometimes gets less. Some carmakers also have been bumping base prices in increments so minor, most prospective customers don't notice. "Zero percent" and other incentives, therefore, have obfuscated the "true price" of the vehicle. The job of forecasting vehicle demand based on changes in price, therefore, becomes all the more difficult.

While important, price is only one variable affecting demand. The forecast model we use relies on inputs from 85 variables. Change the state of any one variable, say exchange rates or the relative cost of used cars, can move the expected level of next year's sales significantly up or down.

Auto component suppliers, let alone assemblers, must make forecasts upon which to plan. Capital expenditures, human resource decisions, and financing requests are all based on forecasts of demand for the firm's products. These decisions cannot be made in a vacuum, nor is perfect information about the future available. An uncertain future requires that suppliers make contingency plans and that identify in particular their vulnerability to strong fluctuations in demand.

A Range Tells You More Than A Point

One of the ways to deal with the large variety of factors that can affect consumer demand is to use scenario analysis. This involves looking at the pessimistic, optimistic, and most-likely scenarios based upon different assumptions for the level of incentives, the economy, interest rates, etc. The chart illustrates the development of three such scenarios for North American Light Vehicle Production through 2006. For each vehicle made in North America, production was forecasted based on a "pessimistic" scenario (less that a 10% probability that actual production would fall below that level), an "optimistic" scenario (less than 10% probability production would be better), and a "most-likely" forecast. The most-likely scenario encompasses the probable effect of all variables and is the point estimate that we hope will come true, but know from experience is highly unlikely to be hit directly on the head.

Build rates for 2003 range from a low of 15 million to a high of 17 million units with the most likely forecasted at 16.1 million. (Please remember, these are production numbers not sales.) For comparison purposes, 2002 will be the third best year ever behind 2000 (17.2 million) and 1999 (17.0 million). Even our pessimistic forecast for 2003 of 15 million units is well above the 1991 recession level of 10.5 million.

While the probability of actual production falling above or below the optimistic and pessimistic estimates is ten percent either way for an individual vehicle, looking at total North American production, the chance that all vehicles will simultaneously attain their optimistic or pessimistic level is very slim. For 2003 production to exceed 17 million units or fall below 15 million would require a very unusual set of circumstances.

Why might 2003 be weaker?

There are several factors contributing to our view that 2003 production could weaken including:

• Incentives have clearly pulled-ahead consumer demand during 2002, increasing the possibility of a payback in 2003
• Household economics do not bode well for further vehicle buying:
• Cash flows bolstered by mortgage refinancing may peter out as home prices plateau and interest rates rise
• Consumer debt loads continue to swell
• Weak profits may constrain car companies from waging price wars
• A glut of used vehicles at low prices is competing for the consumer's dollar.

This is not to say the industry will drive off a cliff. A worst-case of 15 million units of light vehicle production, after all, is still a pretty good year by historical standards.

Then again, it might be stronger

There are things that could go right including:

• Economic growth could accelerate job creation, household income, and improve consumer confidence
• Low inflation could allow interest rates to remain subdued
• The car companies are unlikely to cut incentives by much and could even keep them near their current pace through most of next year
• There is an abundance of new product hitting the market to keep consumers excited and walking into showrooms.

In any case, the pricing dynamics alone make predicting the strength of the auto industry dicey at best. Anyone with a stake in its outcome should be thinking about scenarios and contingency plans, not just a point estimate. The investment and the risks are too great.

(Mike Wall, IRN Senior Analyst, contributed to this article) 

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