The last two years have been exceptional for the auto sector. Sales in the U.S. saw record highs in both years, while China and Europe sales have caught up.

According to IHS Automotive, global auto sales for 2017 are estimated at around 93.5 million units. Moreover, automakers are benefiting from an increase in sales of higher margin vehicles, such as SUVs and light trucks, due to low fuel prices.

On the other hand, automakers bore the brunt of expenses related to safety recalls and negative currency effects. Massive recalls related to Volkswagen AG’s (VLKAY - Free Report) emission scandal and Takata Corp’s defective airbag inflators have been hurting the auto sector in recent years. Rising delinquency rates in auto loans are expected to hurt sales in the future.

Despite the emission scandal, Volkswagen managed to become the highest selling automaker in 2016. With 10.3 million units, it edged past Toyota Motor Corp. (TM - Free Report) that sold 10.2 million vehicles globally. In fact, Toyota has given up the leading position for four years in a row now. General Motors (GM - Free Report) ranked third.

Zacks Industry Rank – Positive Outlook

The distinctive attributes of the auto industry prompted us to have a dedicated sector for the industry in our database. The automobile sector is one of the 16 Zacks sectors, unlike the S&P classification, wherein autos is part of the Consumer Discretionary sector. The S&P has 10 sectors compared with the 16 sectors for Zacks.

At the expanded classification level, the Zacks auto sector is divided into six industries: Auto-Domestic, Auto-Foreign, Auto/Truck-Original, Auto/Truck-Replacement, Engines and Tires. The sector’s retail operations are part of the Zacks Retail sector in two industries: Auto/Trucks and Other Auto Parts. The level of sensitivity and exposure to the different stages of the economic cycle vary for each industry.

The current Zacks Industry Rank is #37 for Automotive - Domestic, #95 for Automotive - Foreign, #74 for Automotive - Original Equipment, #204 for Automotive - Replacement Parts, #104 for Automotive - Internal Combustion Engines, #218 for Rubber – Tires, #77 for Automotive - Retail and Whole Sales and #247 for Automotive - Retail and Wholesale - Parts. As a reference point, the outlook for industries with a Zacks Industry Rank of #88 and lower is 'Positive,’ between #89 and #176 is 'Neutral' and #177 and higher is 'Negative.’

This implies that the outlook for auto-related industries is positive. You can see this in the new Zacks Sector Heat Map that shows the Auto sector at the number 3 spot, behind only Industrial Products and Basic Materials sectors.

We rank all 260-plus industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each.

Sector Level Earnings Trend

The auto sector is expected to contribute 2.0% to the total S&P 500 earnings in 2017. This is double its 1% market cap weight in the index at present.

Looking at the fourth-quarter 2016 results of the auto sector, earnings fell 20.2%. Auto sector earnings are expected to decline 7.3% in the first quarter of 2017 and 10.5% in the second quarter, placing the sector among the laggards. However, earnings are expected to rise starting the fourth quarter of 2017.

Total revenue increased 2.4% year over year in the fourth quarter of 2016. Revenues are expected to move up 0.2% in the first quarter of 2017 and 1.3% in the second quarter.

In line with the weak outlook for the upcoming quarters, earnings for 2017 are expected to decline 4.3% over 2016. Also, revenues for the year are expected to go down 0.6%.

For more information on earnings for this sector and others, please read our latest Earnings Trends report.

Bottom Line

The auto sector is currently facing several opportunities as well as challenges. While low fuel prices, attractive financing options and impressive vehicle launches are driving sales, slowing sales growth in the U.S., rising auto loan defaults and high levels of safety recalls act as dampeners.

Nevertheless, the IHS Automotive projection for global vehicle sales for 2017 is encouraging. At this juncture, we recommend stocks such as Cummins Inc. (CMI - Free Report) , Fox Factory Holding Corp (FOXF - Free Report) and GKN plc (GKNLY - Free Report) .

Cummins has an expected long term earnings per share growth rate of 9.8%. It recorded average earnings beat of 14.5% over the last four quarters. Cummins carries a Zacks Rank #1 (Strong Buy). You can see the complete list of today’s Zacks #1 Rank stocks here.

Fox Factory carries a Zacks Rank #2 (Buy). The company has an expected earnings growth rate of around 16.1% for the long term. Fox Factory posted positive average surprise of 15.9% over the last four quarters.

GKN holds a Zacks Rank #2 and has a long-term growth rate of 6%.