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Market watchers say higher gas prices and rising inflation are expected to curb consumption of big-ticket discretionary items like cars and trucks.welcomia

It has been a rough ride for auto industry investors in recent months: The global semiconductor chip shortage continues to constrain vehicle production and rising costs squeeze company margins, sending share prices in reverse.

Market watchers say higher gas prices and rising inflation are also expected to curb consumption of big-ticket discretionary items like cars and trucks, especially if global economic growth slows, which could happen if interest rates rise too quickly.

Demand for electric vehicles (EVs) is increasing, and more companies are making them. However, their higher price tag and the lack of charging infrastructure in North America are still hurdles for many consumers.

“This is a sector to be cautious on at this time,” says Brooke Thackray, a research analyst with Horizons ETFs (Canada) Inc. of Toronto.

Auto industry investors did have a good run coming out of the pandemic. For example, shares of car maker General Motors Co. and parts supplier Magna International Inc. were each trading above prepandemic levels by the end of 2020 – and both reached record highs in the spring of 2021, driven by increased demand.

Then the semiconductor chip shortage hit after the coronavirus pandemic drove up demand for cellphones, laptops and, later on, vehicles, forcing auto companies to cut production just as consumer demand was steadily recovering.

Russia’s invasion of Ukraine could create more problems for the sector. According to Reuters, Ukraine’s two leading suppliers of neon, which produce about half the world’s supply of the key ingredient for the lasers used to make chips, have halted their operations.

“[The chip shortage] has thrown a big wrench into the ability for the supply side to meet the elevated demand levels that are out there,” says Mike Archibald, vice-president and portfolio manager at AGF Investments.

He points to Toronto-based Magna, the largest Canadian-based auto stock, which posted sales of US$9.1-billion in the fourth quarter of 2021, a drop of 14 per cent from the same quarter of 2020. The company said global light vehicle production fell 17 per cent in the fourth quarter ended Dec. 31, “driven by the semiconductor chip shortages the industry has faced throughout 2021.”

Mr. Archibald has no current investments in the auto space, as concerns around chip shortages and production stops and starts led him to sell his holdings. He’s looking for evidence of recovering production levels before considering buying back into the sector.

“The short term is very uncertain for all of these companies,” he says, but he sees better days ahead for auto companies once production returns.

There’s also strong growth potential for the industry as it moves aggressively into EV production. In Canada, suppliers like Magna and Linamar Corp. are also gearing up their EV offerings.

“The tailwinds in that part of the market are there,” Mr. Archibald says, citing Tesla, the EV “poster child,” and the more traditional auto makers that are continuously rolling out EV models and have ambitious plans for EV fleets in the future.

Investors looking for Canadian-based auto industry stocks could look to aftermarket parts provider Uni-Select Inc., which Mr. Archibald has previously owned. The stock has done well amid the increased demand for used cars in recent months, as the supply of new cars was limited.

He also points to dealership company AutoCanada, which sells new and used cars, as an alternative for investors in the sector.

“The stock has come off,” alongside other car companies, he notes, as vehicle sales slow. “But if you want exposure to the auto segment, this is a way that you could get it directly.”

Mr. Thackray says investors looking to buy auto stocks outside of Canada could turn to the large auto manufacturers like GM and Ford Motor Co., both listed on the New York Stock Exchange. Another option is the First Trust Nasdaq Global Auto Index Fund (CARZ-Q), which is more of a technology play. CARZ’s top holdings include Tesla, chip maker Nvidia Corp., Apple Inc. and Alphabet Inc. – the last two are working on autonomous vehicles.

Still, Mr. Thackray notes the exchange-traded fund (ETF) is small, with about US$70-million in assets. The ETF was down 3 per cent year-to-date, as of March 31, and returned 2 per cent over the past 12 months.

Overall, Mr. Thackray warns that the auto industry is cyclical and suggests investors tread carefully whether buying the new, innovative side or traditional auto makers.

Wes Ashton, co-founder, director of growth strategy and a portfolio manager at Harbourfront Wealth Management Inc. in Vancouver, says most investors who buy a U.S. index fund today own Tesla, given its US$1-trillion-plus market share.

Tesla recently announced a plan to increase its share count to enable a stock split to attract more investors. The highly cyclical stock currently trades at around US$1,000 and has traded between about US$545 and US$1,243 over the past year.

“What investors need to understand is that some of these EV stocks can be very volatile,” he says, citing the example of Tesla, a stock his firm owns for some clients.

“For a lot of clients, it’s fun making money when the stock rises,” he says, “but when the stock corrects, it’s not as pleasant. So you have to be more patient and diversify your overall approach.”

Mr. Ashton says he wouldn’t load up on these EV names, “but I think owning some forward-looking innovative stocks in the auto sector isn’t necessarily a bad thing because that’s where the industry is going.”