Macroeconomics

The financial world is still dealing with the same problems we have been seeing for a while. The financial crisis in Greece is still the dominating topic in Europe. However, since Greece is one of the smaller members of the EU, eyes are more and more directed towards other problematic cases such Italy, Spain and Portugal.

For the time being, the financial community is seriously discussing the future of the euro and global speculators have been betting against the currency, which can be seen in the long and short positions on the futures markets. While until December the speculation was euro long, this position has now shifted to exactly the opposite. In the meantime, investors are holding a long position on the greenback and feel even more convinced by a stronger and earlier-than-expected economic recovery in the US. This extended the decline of the euro, which saw levels as low as 1.3450 against the US$. The fall has now reached more than 10% since the beginning of December 2009 and many are already talking about a weak euro. However, at present levels this is nothing in terms of historical levels.

The US saw production rise 0.9% in January and 72.6% of capacities were used. This was the highest level since December 2008 and many are celebrating; however, the levels are still very low. This is also reflected in the labour market, which is not expanding at all. The Fed increased the discount rate by 0.25% and is consequently indicating that the economy is stabilising and that it may now change its policy of cash injection into the markets.

The global economy is entirely based on expansion in the emerging markets at the moment and all hopes for a general recovery are based on exports. Domestic consumption and growth in the old economies are still insufficient and the enormous budget deficits will not allow private consumption to increase much. Without a rise in growth and creation of new jobs, the Western world hardly has a chance of fleeing from the fundamental problems of higher tax burdens and growing social tensions. The widening gap between the rich and the poor is accelerating in the old economies. This is increasingly dangerous as many have no hope of finding an adequately paid job to maintain their standard of living and government welfare can’t be financed anymore because the budget deficits have grown since the financial crisis.

So, at least for the short term, everything depends on stability and growth in the BRIC nations and possibly some other countries. In the short term, this alone will bring about sufficient exports to overcome the period of weak growth in the Western world. Hopefully this will be strong and will last long enough to give them the chance to do their homework and to find answers to the questions they have to answer.

In the meantime, we are seeing more debate over the risk of inflation and the financial community is still divided over whether commodity prices will rise in response, or whether the period of low interest rates will remain with commodity prices deflating again.

Market intelligence

As the market expected, the industry took a rest during the past two weeks. The Chinese New Year and the carnival season in many parts of Europe resulted in a sharp decline in interest and sales.

The optimists will say the reason for this is that there are no hides to offer, while the market pessimists will consider this as a reaction to the steep rise in prices seen in recent months. As usual there will be a bit of both in it.

In most origins the raw material markets are still in turmoil. Slightly less so when it comes to traders and processors, but packers and butchers are showing a lot of price aggression and are aggressively heating the markets up. So raw material prices are presently rising much faster than the market conditions can really justify, which is not at all surprising as it is pretty normal for a market like this. This applies even more for regions where currency influences against the US$ are playing an additional role.

Specialties such as the top-grade heavy material and calfskins are showing the most robust market performance. It is not surprising that the more valuable raw materials can withstand the rising problems of margins in leather production. For the more average products the headwinds are blowing a bit stronger. Sitting still on comfortable forward positions, sellers of more average type materials are not getting concerned yet but in Europe, where raw material prices rose sharply after the gains of the US$, buyers of dairy cows and average quality males are showing far more resistance and are not showing the endless appetite for hides we saw up to the beginning of February.

This prompted a discussion last week about whether the market rally has finally come to an end and whether we could enter a phase of settlement or even correction. The vast majority of the trade is still pretty optimistic and strongly believes there is still a massive need-to-buy position in the leather industry, particularly in China.

In Europe, the average tanner is using a lot of red ink because of the discrepancy between the price levels of the raw materials and that which is obtainable in the leather market. By consequence, there are rumours that some leather producers are seriously thinking about cutting production. The cost of unused capacity is high and cutting production is a hard decision, but if one has no hope that the price for the finished product will compensate the cost, action needs to be taken seriously, particularly seeing as cash-flow could quickly become an issue as well. Warning signs are starting to flash for the European tanning industry at least.

However, there might also be a psychological factor in the market. While it seems the Chinese tanning industry had a pretty good year in 2009 with strong orders and successful bottom fishing in the raw material market, European tanners were much less fortunate. In most cases, businesses were pretty slow up to the last quarter and results in many tanneries have not been the best performing ones. So, it definitely makes a hell of a difference as to whether you look back on a successful year or whether the year was dull and the outlook seems risky.

Higher prices

Looking at price graphs at the moment, one can see that in most markets we have almost exactly returned to pre-crisis levels. This is proof that leather products have performed well under the lead of China in a quick recovery after the crisis, which possibly reaffirms the function of the leather sector as a leader when it comes to general economic trends. This begs the question of whether the market dynamics are strong enough to push straight through to new highs. Despite the strong performance of the Chinese consumer markets and the cold winter, which has emptied the stocks of many shoe retailers, we still don’t know whether leather prices can be lifted to the next level to justify the present or even higher raw material levels.

The western world is sceptical and the ‘old economies’ are still struggling. Unemployment rates, scary budget deficits and the general outlook are still supporting major concerns. At the same time, you speak to Chinese business people who are far more optimistic and are not seeing the end of the present boom yet. This supports the optimism of many raw material traders who are expecting another strong performance from the markets during the next three to six months. They see the present pause surrounding the holidays as a temporary break in the developments and Chinese retail is expected to remain strong, even after the shopping rush that took place before the Chinese New Year holidays.

If this is true we will see another strong shift in leather production. China, Brazil and possibly India should get most of the benefit with lower production costs, closer proximity to leather products and closer links to the consuming markets. Other tanning areas that are dependent on imports and are delayed with higher production costs will have a more difficult time. Consequently, this will feed our concerns about the industry, for example in Europe, and this can only be eased by further weakness of the euro to support competitiveness.

Another factor we should not ignore is the fact that global beef production is underperforming, which could reduce raw material availability and would support raw material prices as well.

Back to work

In any case, each of these market options leaves a lot of room for high market volatility for the rest of the year. Even with a strong performance in the consumer markets and a rosy outlook for leather sales, the fact is that, with every percentage point the raw material markets rise, the cash-flow position and profitability of many tanneries fades. There will be victims and logical market consequences. We should not forget that if we see a real global recovery the leather pipeline runs far ahead and peaks long before the general economy has seen the results.

To get a better picture of what the market thinks and how the key players see their future we will need to see how the market performs after the return of the industry to normal work in Asia. Many leather producers are taking a longer break in production and a full return to normal levels cannot be expected before the beginning of March.

The few who are still in contact with the markets are trying to do some bargain hunting, hoping to come across sellers who have been affected by the interruption over the holidays. Some are hoping for beneficial currency effects and the chance to buy at lower US$ levels in Europe or Australia in response to the sharp gains of the US$ in recent weeks. We are not expecting them to have too much success in the short term. The shows in Bologna (Lineapelle) and Hong Kong (APLF) are early this year and are not far away. It is pretty unlikely sellers will get nervous before they have had some kind of feedback and so far they are more on the optimistic rather than on the pessimistic side of the game.

The splits market continues to be supported by the performance of the hide market and continues to climb as it recovers from the crisis. Splits are an option in leather production once again and are benefiting from the trends. So we are starting to see the opposite of the situation a year ago when the collagen and gelatine demand were the safety net for splits revenues. Now alternatives to splits are cheaper in comparison and leather production is providing better revenues again.

The skins market is also taking a break. The seasonal buying from China has come to a stop and the preferred winter skins from Europe are finishing their season. Warmer weather and rising freight rates are also a difficult issue. However, progress in this market will depend on market activity after the holiday break and the trend in the cattle market, which we discussed above.

We are still not expecting much market movement in the coming weeks. Currency markets will have an impact, buyers will certainly try to break the market trend and sellers will continue to use their positions to ignore lower bids. It seems there are only a few uncovered positions with tanners at the moment and the strong buying has at least filled their inventories enough for them to resist the present levels for some weeks.

It remains to be seen whether this will impress sellers enough to lower their ideas in the coming week and it will be interesting to see whether sellers are really so comfortably sold and can hold out or whether they have been playing it too hard. We still believe the raw material market has been overshooting and that a correction is desperately required in order to bring leather revenues back in line with raw material prices.

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