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Industry Outlook

While the auto sector has been performing well lately, there are many headwinds that raise concern. Chief among these are the high expenses related to auto recalls. Sales growth in the U.S. is also slowing down, while recovery is Europe is slackening.

However, there are several positives such as low gas prices and impressive China sales. Moreover, focus on vehicle safety is benefiting parts manufacturers, specifically those dealing with automotive safety products.

Still, there are plenty of reasons to be careful about the auto industry stock space for both the short and the long term. Below, we discuss some of the key challenges that investors in the auto sector should watch out for in the coming months and years.

High Cost of Safety Recalls

Safety recalls and related costs have become major issues for most automakers in recent years. Per the National Highway Traffic Safety Administration (NHTSA), automakers recalled 51.26 million vehicles in the U.S. in 2015, setting a new record. In total, automakers announced nearly 900 recalls for safety issues last year, also a new record.

The previous record for both the number of recalls and the number of vehicles recalled was set in 2014, when automakers announced 803 recalls covering 50.99 million vehicles. Notably, these figures only cover the recalls in the U.S. and the global recall numbers are much higher.

Auto recalls are set to be high this year as well, due to the defective Takata airbag inflators, which resulted in significant recalls in 2014 and 2015 too. Per Consumer Reports, the number of vehicles that need to be recalled by 2019 for defective Takata airbag inflators is over 100 million globally. It is the largest auto recall in the U.S.

A large number of recalls are also taking place due to the Volkswagen AG (VLKAY - Snapshot Report) emission scandal although these are not included in the figure given by the NHTSA as this is a standards’ violation and not a safety issue.

Strict implementation by the government and high fines imposed on many automakers for delay in reporting safety issues also prompted many companies to proactively announce safety recalls. Recall-related repair costs increase the financial burden of auto manufacturers. A massive recall can also hurt sales volume as consumers start questioning the brand’s safety.

Plateauing Sales in the U.S.

While U.S. auto sales are expected to be strong this year, many analysts believe that volumes are reaching a plateau. Pent-up demand from the recession period, which drove sales in the last few years, seems to have nearly satisfied. Following record volumes last year, auto sales have fallen in three of the eight months reported so far this year.

A large part of the decline can be attributed to falling sales of passenger cars. From January to August, passenger car sales are down 8.9% year over year in the U.S.

Slower Sales Growth in Europe

Although the European auto market is recovering, it is expected to witness slower growth this year. Per the European Automobile Manufacturer’s Association, passenger car sales are expected to increase only 5% in 2016 compared with 9.3% growth recorded in 2015.

Market Share Concentration

The majority share of the automobile market is held only by a few leading automakers. This makes the automobile sector highly competitive. The top 10 global automakers account for nearly 81% of total vehicles sold, according to

Moreover, high dependence on these automakers makes auto parts’ suppliers vulnerable to pricing pressure and production cut. Pricing pressure from automakers constricts margins of parts suppliers. Simultaneously, frequent production cuts by automakers to cope with market adjustments affect suppliers’ operations.

Some auto industry suppliers that are highly dependent on a few major automakers are Meritor Inc. (MTOR - Analyst Report) , Tenneco Inc. (TEN - Analyst Report) and Magna International Inc. (MGA - Analyst Report) . The full list can be seen in this auto supplier page:

Bottom Line

While the auto industry has several reasons to be optimistic, a number of challenges are rearing their ugly heads. As a result, we would advise staying away from or getting rid of Zacks Rank #5 (Strong Sell) stocks such as Ford Motor Co. (F - Analyst Report) , Gentherm Inc. (THRM - Snapshot Report) and Allison Transmission Holdings, Inc. (ALSN - Snapshot Report) .

Meanwhile, investors who continue to be optimistic about the sector can check out Zacks Rank #1 (Strong Buy) stocks such as Superior Industries International, Inc. (SUP - Analyst Report) , Tata Motors Limited (TTM - Snapshot Report) , and Standard Motor Products, Inc. (SMP - Analyst Report) . You can see the complete list of today’s Zacks #1 Rank stocks here.

Check out our latest Auto Industry Outlook here for more on the current state of this market from an earnings perspective, and how the trend is looking for this important sector of the economy now.

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