Macroeconomics

The financial markets are now being shaken almost daily with both good and bad news, and this is reflected in the reports and opinions reported in the media.

Most of the numbers published indicate a further recovery of the global economy. For example, the US GNP published showed a growth of more than 5% in the fourth quarter and the purchasing managers index (PMI) rose above 88 index points, which was more than expected. A rising PMI generally indicates rising industrial production and more faith in consumer activity, or just a replenishment of inventories that had simply run too low.

However, the unanswered questions that remain are: how good is better and how sustainable is it going to be? Belief from the national banks appears mixed. While the Fed and the ECB are still warning that the recovery is not yet stable and are still keeping interest rates pretty low, others are already seeing more stability in their countries and are starting to collect excess liquidity from the markets. This particularly applies to the Chinese and Indian national banks.

Other Asian countries, for example Thailand, are worrying about rising consumer prices as well as the risk of new asset bubbles. If one looks at the investment banks’ profits, it’s clear that the money that has been pumped into the markets isn’t where it should be. At the same time, many producing companies are still complaining about the insufficient credit available.

And so the discussions continue about deflation and inflation scenarios, about V, U and W shapes in the recovery and everyone can choose what suits them best. The typical man on the street still seems pretty unimpressed and in most countries people are worried about their jobs (if they still have one) and the cost of living.

Another issue is the stability of the euro. Having been one of the stars of the currency markets in 2009 it is now becoming a concern. The serious situation in Greece and concerns about other countries are weighing on the market and the euro has lost almost 10% against the US$ since the beginning of December. It is coming down as sharply as it went up. Nevertheless, the euro is still pretty well valued and it might just be a correction to normal valuations as the other global alternatives are not really free of risk potential.

Oil remains in a tight trading range. While speculators are impressed by the outlook for a recovery in the global economy and are using dips to buy, physical demand is down despite the cold winter in the Northern hemisphere. The physical supply and demand situation is not an indication of any shortage or a reason for sharply rising prices.

Market intelligence

As happens in a longer market cycle, we could have just changed the dates from our last report, because fundamentally nothing has really changed over the past fortnight.

The firm trend continued and due to currency effects it was more pronounced in Europe than in the US, for example. Demand did not fade by much although we have the impression that the total trade volume may have been a little less. Maybe it is just swinging at the moment from one origin to another, pushing prices incrementally higher in the different regions. Apart from consistent demand, supply is the main driving factor these days. Most of the main supply regions of the world are reporting lower kills and beef consumption has suffered because of the 2009 downturn. Less demand or the shift to cheaper options such as pork or poultry is having a clear impact.

Because there is a lack of real day-to-day market news, let’s spend a moment analysing what has actually happened since the markets started their rollercoaster ride after the financial crisis of 2008. Of course we have to work on assumptions and our readers should not really look at the numbers. They are used for more explanation purposes rather for statistical reliability.

In October 2008 the product flow slowed significantly. Contracts were cancelled, tanners almost stopped buying and production dropped significantly. Let’s say by about 50%. Production stopped and we think it is a fair assumption that for a period of three months production dropped by 50%. In the first quarter business stabilised at very low levels and tanners were largely using up their raw material inventory. Let’s also assume that only 50-70% of the hide production was used up and purchased. So, for the six month period to April 2009, about 30-50% of the global hide production had been stocked in the hands of the producers and this does not count the hides that might not have been collected and destroyed. This did account for a reasonable number, but should not play a part in this evaluation.

With prices having fallen by 50-80% from April onwards, buyers were taking advantage and, led by China, inventory replenishment started and purchases quickly rose to 100% of production. We estimate that in the second quarter of 2009, hide production and purchase were already balanced. For better-quality origins, demand was certainly higher than the kill, while the more economical regions had possibly not reached this level yet.

In the third quarter, demand continued to grow and prices accelerated with a short pause towards the end of the quarter. In the fourth quarter leather demand fully stabilised and the reduction of inventory in the pipeline since the end of 2008 needed to be balanced. So the final overhanging stocks were absorbed and by the end of 2009 we were back where we were in the summer of 2008, with the only exception that supply (kill) is today at least 5-8% below the average levels of 2007-2008. At the beginning of 2010 we ran into a shortage of material. While a surplus hide can always be stocked, a missing hide cannot be compensated and substituted. The problem here is that any of these supply-demand scenarios can actually be converted into a 1:1 market and price ratio as it does not implement stocks and expectations in the pipeline.

The opposite effect

This might be the biggest problem of today. As the assumption of a severe and long-term crisis at the end of 2008 led to an exaggerated raw material inventory reduction we might now be in the opposite state. Replenishment and optimistic budgets could possibly create a similar effect on the other side with the only difference being that the kill is down and so the market balance has shifted to lower numbers.

This leads us to the question of how and where the additional volumes of leather products have been placed in 2009, excluding the possibility that they are sitting in some warehouse around the world, which I think can be ruled out.

From the available statistical data we know that private consumption in the Western world was flat or down and at the same time we know that private consumption in the emerging markets under the lead of China was up. Flipping back one will remember that in 2008 tanners in the Western world were complaining about raw material prices in view of their businesses and we always pointed out that local consumption in the Middle East, the BRIC countries and other places in the Americas, Indonesia and Africa  were showing massive growth rates.

Fashion and apparel is one of the first sectors to benefit in an unsaturated market. The low raw material prices in 2009 made this type of product much more affordable for lower-income areas and supported quicker consumption of the stocks along the pipeline. This left producers with far less raw material in the markets than they ever expected.

If the leather pipeline was to work according to the normal pattern there would be hardly anything to discourage the continuation of a long-term price rise, and that is what many people are expecting. However, some pundits are pointing out and reminding us of the critical price levels leather has always had and still has. Passing certain levels or threatening to do so is scaring many manufacturers away and they are reacting either by dumping leather or by reducing the amount they use. With oil still trading at levels far below 2008 rates, and as there is little indication that prices will double in the short term, long-term contracts for cheaper leather substitutes can still be booked.

So there is actually very little temptation for manufacturers to maintain and increase their leather consumption, providing it is substitutable. So leather demand can only be held at present levels by organic market growth if consumers prefer to buy this material.

Chinese buying power

In the Western world we know that brands and retailers are extremely price-sensitive, as are the consumers. There is hardly any indication that normal leather is so prestigious at the moment that people are willing to spend a lot of money on it. That has always been the dream of the industry, but so far it has not been too successful (mainly in upholstery, of course).

So the hope, once again, is in the Chinese market. If we remember Europe 35 years ago, the consumer at that time considered leather to be a premium product and a leather sofa was something like the middle-class car is today. Climbing the income and social ladder it was a demonstration of success and consumers were willing to spend for it. If that is the case, it is good news for Chinese tanners and bad news for the European ones. They (the European ones) would most likely get the smallest part of the cake if their EU customers (furniture manufacturers) do not make quick and successful progress in terms of exports to China.

In actual fact, there are suggestions this could happen, with many reporting that Chinese upholstery tanners are very busy at the moment and some are even shortening their New Year vacations, which always indicates a full order book. The sharply rising prices for dairy cows to levels that have to be considered pretty high even in historical terms could also be an indicator that premium prices are being paid for good-quality upholstery leather in China.

If this is true, the firmer US$ is also good news for European tanners as this makes them more competitive in the market again with some of their specialty items and the Italians, still being the masters in terms of leather production from economical raw materials, could try their luck.

Splits and skins

The splits market continues to move in sympathy with the hide market, but it is not really convincing. The splits related to leather production are certainly still an economical alternative and tanners are also trying to get a better return for their by-product. From the gelatine and collage market one hears, however, there is some pressure on prices due to the abundant supply of alternative materials.

The skins market is still firm but has lost some of its momentum. Having taken big strides since mid-December we haven’t heard of any further advances and the Chinese buying season is also coming to an end.

The weeks to come should, under normal conditions, offer at least a short break. China is now quickly winding down for the Lunar holiday and in many parts of Europe a short break for the carnival season could offer a bit of a time to sort things out over the next 10-14 days. No matter how good things look and how much panic and need there still is, a period where people can take a break and look seriously at their individual situations is long overdue.

The fact that most of the industry is no longer profitable at the present raw material levels and leather prices cannot be ignored. Times like this happen, but they can’t last forever without adequate corrections on either side. Sources have already reported that, during the Chennai fair, Indian tanners clearly uttered that their customers were not willing to adjust leather or upper prices to anything like the levels needed.

With the new and advanced dates of Lineapelle (mid March) and the Hong Kong show at the end of March we will have better trend indicators sooner this year. So risks should still be taken into consideration and only with very clear convictions and arguments should people continue to jump into the market with both feet. Those who were not willing to buy a year ago should look for pretty good reasons before they buy today.

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