A sizzling summer for vehicle prices

As spring turned to summer, used-car prices began to heat up. Without a big shock like last year's hurricanes, it is extremely rare for used cars to appreciate like this during summer. Yet, our weekly price index shows the most-sold vintage of vehicles at Manheim — 3-year-old vehicles — are worth 2 percent more than they were just eight weeks ago.

Think about this: A depreciating asset is worth 2 percent more than eight weeks ago, when normally it would have lost about 1 percent of value.

The Manheim Index set a record in July. The index is based on all vehicles sold at Manheim and is the best indicator of what dealers are paying for used vehicles.

The record bested the one set in October at the peak of the replacement demand frenzy after hurricanes Harvey and Irma. This time, no natural disaster has wiped out supply and created replacement demand.

Generally, prices increase when a demand-supply imbalance occurs. Even though higher prices should encourage an increase in wholesale supply, at this time of year and at this point in the auto cycle, wholesale supply cannot increase enough to accommodate. Given that the situation is fundamentally caused by a surge in demand, higher prices make matters worse and further reduce wholesale supplies.

Higher prices lead to a higher probability that leased vehicles at maturity are worth more than their contract value. The consumer and/or dealer is more likely to buy the vehicle, resulting in fewer off-lease vehicles going to auction.

Lack of inventory against strong demand reinforces the perception that the market has an inventory problem. Scarcity encourages buyers to act faster and accept higher prices, extending the demand-supply imbalance.

Dealers are not buying irrationally. Retail demand is causing this situation. We estimate used-vehicle sales increased 3 percent year over year in July, with one fewer selling day. The annualized pace of used-vehicle sales is up 1 percent over last year to 39.5 million, a new peak for this expansion period. We estimate the July used SAAR at 39.2 million, the strongest July in six years.

The robust demand for used cars is partly because of a strong economy, with mounting affordability challenges for the consumer favoring growth in used-vehicle sales at the expense of new. But that demand driver isn't new. These conditions have supported strong used-vehicle prices for more than a year.

Only one event happened close to when used-car prices started to defy gravity: President Donald Trump's announcement of a proposed 25 percent tariff on imported vehicles and parts.

The used-vehicle market is adjusting for the possibility of higher prices. These higher prices and the related declining supply create a psychological feedback loop for consumers and dealers, encouraging buying now with the expectation that prices may be higher later.

The demand-supply imbalance is not limited to used. We see evidence of new-vehicle price strength along with declining discounts and stagnant incentives. This is an odd time of year to see less discounting, as usually the model year changeover brings bigger incentives and more discounting to move the older models. But stronger retail demand against limited supply enables manufacturers to trim incentives and discounts.

On the used side, peak wholesale volumes are timed for spring, not summer. Rental car companies are in peak summer usage months, not an ideal time to sell off fleet. Fleet companies are likely now seeing less attractive pricing given the stronger retail demand. The most flexible source of wholesale supply comes from finance companies offering lease pull-ahead programs.

This spring, most of the strength in used-car prices was in affordable segments — compact and midsize cars. The more affordable segments still see the strongest performance, but the summer surge is a tide lifting nearly all boats. Across segments, only sports cars have not had an increase in their 3-year-old weekly price index over the last eight weeks.

This trend can't last long, but it may persist through summer and early fall until the tariff threat is resolved and/or negative economic news occurs. Even in the absence of a change in politics or the economy, price increases cannot go on forever as eventually the market will reach a breaking point for payment affordability.

While used retail sales will peak soon, we expect they will plateau at the peak and not decline for at least a year. That means demand should be consistent once the sense of urgency calms down. Then supply flows will have a greater impact on pricing. Supply will likely increase marginally leading to faster depreciation.

When the market reaches the point that supply is more in balance, the faster depreciation should boost sales volumes, not hurt them.