For a rapid video history of Volkswagen (VLKAY) from Adolph Hitler to present, see Bloomberg, “Volkswagen’s Eight-Decade Road to Disaster.” For a report of possible costs to VW compiled by CNN see “Volkswagen scandal may cost up to $87 billion.” Credit Suisse estimates the cost to be as high as $87 billion, or 160% of the BP disaster cost. VW has reserved about $8 billion so far.
Market pundits forecast disaster for VW. They may be correct. Those who thrive on fear and panic have then extended that forecast to the entire German market. We disagree. Others have piled on and made it Europe-wide. Nope. Too extreme. And still others have the worldwide auto sector and related manufacturing going in the tank.
So, who is right? Does the world come to an end? NO! Does the VW scandal trigger a recession? We say no.
Does VW survive as a company? Probably yes. Is it wounded seriously? It seems so. Will the German government have to step in and help it survive? That one is much harder, as it involves politics; and the issues now include the uses of diesel fuel and changes that will be required of vehicles that run on diesel.
So for Germans and other Europeans who have a diesel bias, this is much bigger than VW. The Citizens of Europe are waking up to the poison that VW has been spreading. They are breathing poisonous oxides that are created from the combustion of diesel, including nitrogen oxides (NOx). We would expect heavy and intensifying political protests now that diesel-generated NOx is on the radar screen and the world’s largest auto producer has been caught and charged with cheating on the emission test for NOx.
What about the VW internal and public cost estimates? We think the company’s first reserve estimate is certainly too low. In the US alone the possible fine is $18 billion. That figure is based on 482,000 cars sold and a Clean Air Act theoretical fine of $37,500 per car, if the Department of Justice pursues the maximum penalty. By way of comparison, The Economist (September 26, page 24) reports that General Motors’ fine for ignition problems that “claimed 124 lives” was $900 million. They also list a Toyota fine of $1.2 billion as the settlement cost in a dispute over “unintended acceleration problems.” Toyota (TM) recalled 8.1 million cars. So far 11 million VW cars have been identified as affected. But this time may be different in that the cheating appears to be intentional. We shall see if the Obama Administration seeks the maximum, $18 billion fine.
So why are initial company estimates low when there is a disaster? Why did BP do the same thing? That question is simply answered. The issue for a company is, how much am I going to pay and to whom. The higher the initial estimate, the more a company declares in advance that it expects to pay; so the company has an incentive to keep estimates low. The second issue is what happens when reserves to cover the problem are increased. Income falls, and balance sheet risk rises. That invites scrutiny of the company’s credit rating, and downgrades can occur. Downgrades raise financing costs, and market access may be impaired.
Can we get specific with regard to VW? Yes. “Class-action lawsuits will arrive at the speed of a turbocharged Porsche,” says The Economist. The auto financing operation is large. When General Motors (GM) was hit during the financial crisis, its financing arm, GMAC, needed a bailout. That may happen to VW. The Economist estimates that VW’s financing operation today is about as large as GM’s was six years ago. VW also has about $230 billion in derivatives exposure. The company routinely hedges currency risk and interest rate risk. Until the scandal, it was viewed as a highest-grade counterparty. A downgrade in its risk profile would immediately require VW to use its approximately $80 billion in liquid assets to shore up the counterparty risk profile.
Diesel vehicles make up between 40% and 65% of car sales in Germany, France, Britain, Italy, Spain, Belgium, and India. In Korea the figure is 23%. These are 2013 numbers reported by The Economist. Will a major change be forced by the revelations about the very high levels of NOx emissions from diesel vehicles? Will little Belgium, an intensely protectionist socialist country (which recently kicked Uber out), be forced to change because its citizens declare they have breathed enough poison? We shall see.
OK. Enough recitation of numbers and facts.
Our forecast is clear. People don’t want to breathe poisons, so they are going to require their governments to change policy. Diesel is under attack. Companies will fill voids, and the global auto business will continue to be a growing, not a shrinking one. Electric cars, self-driving vehicles, and other new technologies are only in the early stages of their fulfillment of Moore’s Law. Note that the US saw an annualized sales rate of 18 million vehicles last month. That is the above estimates and the highest rate in 10 years.
Thus, we conclude that this catastrophic scandal hurts the perpetrator of the alleged emission testing cheating scheme, and it helps others who did not cheat. VW’s missteps will result in downward pressure on diesel and opportunities for companies that can offer viable alternatives.
We do own VW. We own ETFs in managed accounts, and VW is one the many stocks that make up certain ETFs. If there was ever an outlier surprise that decimated a stock, it is this one. At the same time, the value of using ETFs instead of taking single-stock risk is validated by the scandal. We do not own single stocks for our clients. We remain bullish for equities on a selective basis worldwide using ETFs.
We believe the VW scandal will encourage the European Central Bank to remain stimulative longer than originally planned, as the European manufacturing sector works to recover from the VW affair. In Europe that means negative interest rates are likely to be around longer and may even go lower (more negative). Remember, negative interest rates in the second largest capital market block in the world place a downward pressure on all global interest rates, including in the US.
We’re sending this from Europe. A short trip has two items now in focus: (1) Negative interest rates – will they spread? Will they go lower? (2) The future of diesel – will things change? Will protectionism prevail over poison? Note that Germany has just issued 370 million euro denominated, 2046 maturity, index-linked bonds at an average real yield of -0.09%. That is correct. Germany has borrowed for 30 years at a negative real yield. The bid to cover ratio was 1.9.