Market Intelligence—15.11.11
15/11/2011
The never-ending story of the European debt crisis has the financial markets still in a tight grip. Resignations or announcements of governments and or presidents in Greece and Italy have increased the hope that the austerity programmes in these countries and the necessary political decisions can be taken and the countries can be led back to a track of growth and stability.
Italian government bonds reacted positively and the interests Italy had to pay investors to attract their investments fell back from record levels, but many pundits are not sure that the expected political changes in the country will be implemented smoothly enough or the interim government receive enough support to do what has to be done.
The outlook for the global economy is continuously under revision. EU growth projection for 2012 has been reduced to a meagre 0.5 %. Christine Lagarde, head of the International Monetary Fund, has prepared EU citizens for a period of slow growth and subdued economic conditions for a decade. Well, all depends on developments in emerging markets and if growth there can support the EU economy. This is not to mention the bleak situation in the US and Japan where labour markets are not performing any better.
In Asia governments and national banks are starting to become more concerned about their economies. Squeezed between inflation due to rising food prices and slowing exports they have to decide between economic stimulus through lower interest rates on the one hand, and the fight against inflation by raising interest rates on the other. China’s prime minister has already indicated that slowing export demand will require more domestic consumption and more flexibility with financial policies. Retail results for October in China were far below expectations.
Despite increasing concerns about global growth energy prices are rising again. Oil prices have slowly risen and is trading back at levels well over $110 again. One can’t actually erase the feeling that a lot of speculation is involved. Demand seems too slow and supplies from Libya are returning to the markets. Physically it seems there is no shortage in the market and so it must be financial investors pushing prices again. Other markets including the currency markets are playing yo-yo again.
Daily news is driving prices and stock markets to fluctuate by more than 3% in a day. It’s the same with the currency markets were the euro loses or gains three cents in day. Normally stock markets trade the future and according to this the markets are far more positive than the analysts. Let’s see who is right.
Market intelligence
In our last report we gave the market a fair chance of hitting bottom. That was far from what has happened. Prices retreated on a broad front and continued to fall all through the past two weeks. What have disliked for a long time that reports are still used by sellers to paint a far rosier picture of the market and price situation than is actually true. This may all be with good intentions to prevent sharp corrections and the negative consequences, but it is increasingly driving the real market and the reported price levels apart. This might be unproblematic for those who don’t care about benchmarking and price references, but for all others the situation is becoming problematic.
Let have a look at the present downward cycle we face in the raw material market, at least in the bovine section. Just to bring everyone to a similar level of information we would like to recapitulate what the situation was and what has brought us to the present market conditions.
Raw material prices had gone up since the 2008 crisis. Recovery in the old economy and persistent high growth rates in the emerging market led to rising consumption and enough optimism that the supply chain was willing to increase inventory. This came to a climax in the second quarter of this year when strong demand and a positive outlook resulted in the opinion of raw material producers that their products were still undervalued and had further upside potential. Tanners and manufacturers had to bite the bullet and with the impression of shortage and full order books they felt that there was no option but to accept the raw material prices and to hope for higher leather and finished product prices. Wholesale and retail were willing to stock up under the impression that positive growth and rising inflation would bring consumers into the shops, combined with a fair chance of rising retail prices.
Any warning that things might take a different road was unheeded. Leather producers were unhappy, margins eroding and turning negative, inventories along the supply chain were considered to be a good investment and concerns were merely on financial budgets rather than about the trend.
In all this enthusiasm there were a few warning voices saying that the price of leather should be watched. No rising leather prices meant no real potential for rising or stable raw material prices. Raw material suppliers saw only what they wanted to see, fantastic news from the luxury and automotive industry. Amazingly, the problem was not with the suppliers of premium quality raw material, but with the ones who just distribute raw material that is suitable for standard and commodity production; it was they who were not willing to value their product adequately. In fairness, no supplier can be blamed for taking what the market will pay.
From the demand and purchasing side the trouble came from speculation and the easy money in particular still available in China until the summer. It was too inviting to take the cash and to invest in raw material that, for an outsider, had so much potential according to the news from the luxury and automotive sectors. The smart money did not continue buying into the summer and a number of the ‘old dogs’ in the trade were already mentioning that they did not like the quality of the buyers any more.
By early summer it was obvious that the leather market was not supporting the price trend and producers has asked their designers and product managers to reduce the amount of leather in finished products for the next season. Most of the big players on the supply side were not willing to accept the facts and were betting on a return of demand after the summer break; they believed in their dream of controlling the supply side and that hides and skins would be a scarce product. Fundamentally that might be true, but we are not in a competition between supply and capacity. In the case of leather, the prices of substitute materials have to be taken into account.
Many will now again not admit that their position was wrong, but they will blame the EU debt for the weak performance of the market. Well, they should actually accept that the decisions about leather consumption in this season were taken far before the EU crisis developed into the present situation.
Over the summer the suppliers were building up stocks or parking overproductions in semi-finished materials other than sitting down and evaluating their fair chances to place the material at the desired prices levels. Not even the fact that price levels have been at or close to historical highs made them think. Even at the beginning of September at the All China Leather Exhibition in Shanghai a lot of sellers were still pretty stubborn in their opinions and the ones who were willing to consider the market received criticism. When the problem is the slaughter industry’s, they just lose their own money, but processors, traders and tanners have had to endure serious margin problems because of the strategies of the beef industry, although they will never admit.
What are now the consequences and what does it mean for the actual situation and the short and medium term future?
Despite the fact, that nobody has exact numbers we believe it is fair to use rough assumptions to explain what is happening. From the summer onwards large producers of leather globally, in particular in China, were complaining about a shortfall of orders. Tanners, chemical companies and leather traders were and are talking of a downturn of between 20% and 30% in the shoe industry. For upholstery the figure might be a bit less, perhaps 10%. Automotive and luxury production might be stable. However, the demand for raw material is down by around 15% or 20% (just as a guide). If we consider on top that inventories had been planned and held for a stable production and order situation one can understand why the raw material demand has been so insufficient in the past months.
Furthermore we have seen a restricted cash situation and the EU debt crisis as an additional psychological factor making it far more difficult for many to maintain an optimistic view for their business future.
Until the spring inventory in the pipeline had been shifting from slaughterhouse to retail level and that explained why producers needed such a long time to accept the market conditions. Looking at their order books and at the empty warehouses and comparing that with their business projections made a lot of people believe that the shortfall of sales would be only temporary and there was no serious risk for sales and consequently for their prices. It took more than three months to have them understand that a new cycle had started as a result of the high raw material prices and leather demand was and is presently substantially lower than the present raw material supply.
The question to be answered is solely how long is this cycle will last and how far will the pendulum swing back this time. No market trend is a one-way street.
The good news is certainly that so far, while demand for leather and consumer products may not meet (the overstated) expectations, generally the demand is still not in recession mode. Retail sales may not be growing all over, but they have not slumped. We are still in front of the winter shopping season and sales can still surprise us positively in the end. However, decisions for and production for the current season are already made and for any re-ordering it is too late. So, we have to look to the future.
The fundamentals are actually not really worrying. Global population is still rising, the emerging markets are still producing growth and so far it doesn’t seem that the debt crisis is a problem of the global private consumer. He might be more cautious, but we are not in anything like a crisis. However, the consumer is still price conscious and he can only buy what is offered to him. If leather consumption has been reduced, because the price of the material has been too high the consumer can’t buy the product and consequently also demand cannot be stimulated in the short term. At best, existing stocks can be cleared more easily. The key factor is that leather prices have to be reduced to levels that will make leather a material to be consumed in the volume it is produced.
The situation isn’t actually so bad. Raw material and leather prices do not need any large adjustments. For mass production we believed that leather prices needed a 10% decline and raw materials about 20% from their highs. A good proportion of this has already been achieved. The problem is that it might have been too late. The market needs the clearance of overhanging stocks along the supply chain. They might be higher and lower in individual cases, but generally there are still stocks swirling around that need to be moved to bring the market back into real solid balance. One company selling this material to the next doesn’t consume them; the problem is just in another person’s hand. We need final product consumption to perform well, or a decline in supply. So, it will need a strong performance of consumer sales in the coming months to settle the situation quickly or we might have to wait a little longer for a longer-term balance to be achieved; that would mean that the long-term cycle of prices will remain in a downward channel for some time.
The weeks until the end of the year could remain problematic because we have additional factors playing into the situation. There will be a production break in Europe due to Christmas and the end of the fiscal year at the end of December. In Asia we have the break in January with the consequences for shipment and production between now and the New Year 2012. Many Chinese tanners are already advising of an extended production break due to the lack of orders and to manage their inventories.
However, for the first quarter we are a bit more optimistic. If our theory that leather consumption is just not meeting expectations but is still reasonably stable, then the inventory problems could be managed slowly. Tanners and manufacturers are still aware that raw material is in limited supply and we don’t believe that they would allow prices to drop as rapidly and as low as in 2008. There are still strong hands in the industry who know that correctly priced raw materials are still the best investment one can have in the long run. How many smart buyers made good profits, because they had the courage in 2009 to invest in raw material despite all the concerns? We believe, that the strong buyers are still there and this will prevent the market from any unreasonable downward reactions.
The split market is starting to face more headwinds. Although the balance of supply and demand is still in better conditions than for hides, tanners see the price trend for hides and feel it is now also their turn to adjust levels. At least the market for lime splits has strong support from the collagen segment and this maintains the strong floor under prices for this product. For wet blue splits conditions could be a little worse, but generally the market is in better shape than for hides.
The skins market is presently still holding pretty well. Lining materials and double-face skins are still in limited availability and are holding prices pretty steady. There is bad news from the garment nappa market. The big manufacturers in China are reporting very low orders and interest and some are even talking about an almost zero interest situation at the moment. The decline in prices for bovine alternatives may also play a certain role. The situation makes it pretty difficult to read the skins market now. Skin prices for the top quality and the luxury end are still at record highs. Also high-quality lining and double-face material can still find enough buyers, but everything else seems to be also in front of some adjustments. The Eid al-Adha festival last week has also increased slaughter and supply, which will in our view make the market situation for average quality skins not much easier in the short term.
For the coming weeks we have to believe that the time of uncertainty and concern will persist. We have to wait now to see if politicians in Europe can convince the markets that they can handle the situation. It seems that the markets can’t handle much more uncertainty and bad news. There are now only a few weeks left in which sales can be generated and for the moment it doesn’t seem that the Asians have enough confidence yet. Buyers feel comfortable with their raw material stocks at the moment and don’t feel it is the right time to be overly active. Everyone is trying to test the market to see how much potential they will still have to save on raw material.
The critical question is how leather prices are reacting. One hears rumours that leather buyers are also pushing hard for lower prices. So, we enter the coming weeks with persisting concerns and sellers will do all to stabilise the market, but we don’t think we are there yet. We believe that it might need until mid-December until something like a bottom will be reached and according to our calculations another decline could still be necessary to lay the ground for a safe and secure bottom, which could lead us into the new year.
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