Macroeconomics

Throughout the period under review (May 3-17), the wider picture was dominated by the ongoing increase in oil prices. On the day of writing, prices per barrel broke through the $1.41 barrier and most experts are predicting further increases.  Though we are no great followers of ‘the experts’, even if prices remained on average between $35 and $40 per barrel, the medium term consequences would be massive.

Some time ago, we dealt with the possibility of global inflation returning and increasing energy prices are traditionally a solid base for such a development. Considering that many other essential commodities are currently trading at similarly high levels, the assumption that inflation is on its way back can no longer be ruled out.  While in the United States energy prices are the main worry, in Europe there is also the rising cost of healthcare and other social costs to add to the family budget.

The effect of rising oil prices is not just seen at the petrol pumps.  In the medium and long-term they are also reflected in the price of many consumer goods, the manufacture of which is often oil-dependent.  It even affects leather, as the chemicals used to produce the product are becoming more expensive.  The price of competing products such as microfibres is also likely to rise sharply when long term contracts are renewed.

Rising oil prices have both long and short term impact on the family budgets.  In the short term, higher energy prices mean less disposable income, for expenditure on furniture, cars, garments or shoes.  Higher fuel prices traditionally slow the purchase of new vehicles too, so the only hope for this market is that sales of more fuel-efficient automobiles will increase. In the medium to long-term, inflation will also rise, something that is traditionally answered with higher interest rates, falling stock markets and real estate values, reducing the wealth of the population.  This in turn means less consumer spending on high price items, coupled with an increase in spending on low price items to protect against further price rises. It is therefore not all bad news for products made from leather.  But there is quite a long way to go before we really know whether the spectre of inflation has been reawakened.

Market Intelligence

Even though we say it ourselves, the previous edition of Market Intelligence had an exceptionally good feel for the market. Our prediction that the positive tone set by the shows in Italy and Highpoint would fade was proved right as the mood of the industry returned to the levels seen before the fairs.

Our prediction that the American steer market would bottom out was also proved right as the period of price adjustment in the US market came to an end.  Prices have reached levels where they are once again competitive with the alternatives from Europe.  When a tanner in Asia has the option to choosing between American and European hides he is now more comfortable with the former.

We are now of the opinion that the need for price adjustment between the bigger supplying regions is over. This leaves us free to return to the analysis of where we stand in relation to the longer- term trends rather than discrepancies between the current value of the different raw materials available.

The main problem concerning the raw material markets in the past months has been the large difference between the prices of different raw materials and also currency movements. This has led to the situation where markets such as the US have suffered a downward correction, despite the good demand for raw materials.  In our view, prices are now pretty much in line with demand.

In our view the main questions concerning the coming months are;

a)      What are the main seasonal factors going to be?

b)      What is the outlook for global consumer spending?

c)      How will the different leather sectors perform in the coming months?

d)      What will the main price trends be?

e)      What will be the main developments in the financial markets in the second half of the year?

Taking question a) first: Although the hub of manufacturing, Asia, is less impacted by seasonality than Europe, the fact remains that the second quarter of the year is traditionally slow in this part of the world.  Upcoming summer holidays in the automotive industry, the low season in furniture sales, the change of season in the shoe industry and low production in the garment industry – all of these factors will therefore combine to keep raw materials demand in check.

Turning to question b), consumer spending and the outlook for retail sales remain very positive.  With the exception of Europe, most consumer markets performed strongly in the first quarter of 2004 which means retail inventories for leather goods should be at a normal or even low level.  When discussing global consumer market, one should not just consider the traditional centres of the USA, Japan, Western Europe and Asia.  We should also include the fast-expanding markets of the former Eastern bloc and in particular Russia, which probably today has bigger growth rates than any other market. The high price of oil and other commodities such as metal is boosting Russian export revenues and is therefore likely to continue to have a very positive effect on consumer spending in that country.

However, what is good for one country is often bad for another. In that predictions for second half growth in the Western world were made on the basis of oil prices of around $30 per barrel, household energy costs will be about 30% higher than envisaged. While this is not a major factor during the summer months, its impact could be quite dramatic during the winter.  Consequently, energy prices will need to be closely monitored. We have already dealt with the medium and long-term influences of inflation and how these could amount to more than short term budget problems for the average family. It is definitely too early to decide what impact increased energy costs would have on global consumer spending in the second half, but we will keep an eye on the subject, because it could well be that it is not just consumer spending that suffers. The wider global economy could also be affected, as the energy bills for countries as a whole would rise sharply, in turn affecting the general financial markets. And rising inflation would only be one issue to deal with as many analysts and experts are predicting a further sharp rise in oil prices. History tells us however that exaggerated price levels are normally answered by a sharp reduction in demand, if only because commercial organisations and consumers cannot afford to use as much of the commodity as they would like. The largest consumer of raw materials and energy, China, could therefore be in for a shock when prices of raw materials do not allow profits anymore, or if the government steps up its control the economy by imposing import restrictions.

In the coming months therefore we expect upholstery leather production to slow, shoe and leather goods to remain stable, and for garment leathers to see some improvement in demand and production.  Due to the rising price of sheep and lambskins, bovine garment leathers are also likely to return to favour.

As far as prices are concerned, we see two conflicting trends emerging. Despite the seasonal slowdown in leather production, we gain the impression that many tannery inventories are running low. Under normal circumstances, this would generally support raw material prices and the desire of sellers to obtain higher levels for the product. 

However, tanners are currently having to fight massive price pressure from their clients.  Looking at the profits posted by most of the big retailers and brand names in recent months, one has to wonder whether this kind of pressure, stemming from their massive bargaining power, is fair. Either way, there is unlikely to be a change in the balance of power in the short term.  Even the automotive tanners, who have had it comparatively easy, are starting to feel the heat. This can be seen in the trend toward cheaper raw materials and finished leathers, as well as the continuing shift in production to lower cost countries.

Against this backdrop, we consider it unlikely that raw material prices will break out of the trading range that has been in place for some time.  The best one can expect is for a continuation of the trend toward stable to rising prices in the cheaper origins, and that the medium to higher priced producers will continue to resist the price pressure from their customers. Leather suppliers serving the luxury end of the market will continue to experience stable if not rising demand, but this forms such a small part of the wider industry that its effects are likely to be negligible.

We believe the financial markets have some unpleasant surprises in store for the second half of the year. We are not quite sure of what these will be, our biggest concern is inflation and rising interest rates. If this were to be realised, the real estate markets would take a tumble and the stock markets also take a hit.  We are also expecting major developments in the currency markets, if only because the financial markets have shown themselves incapable of providing  the major currencies of the world with any clear path to take. The narrow band most currencies are currently trading in will most likely be history by the year end.

The split market was reasonably steady, dispelling our previous worries.  However, it is not completely out of the woods as splits of low substance or low quality are facing more price pressure at the moment. Nevertheless, good quality splits continue to enjoy steady demand and insufficient supplies. This helped to keep prices basically steady across the board.

Lambs and sheepskins started to receive more and better demand. Turkey and China entered the market and bought whatever they found reasonable and at the right price. So, those who were hoping for reduced price levels were disappointed.  However, sellers who put their prices up in the year did not realise the success they expected.  Good quality lambskins received enough interest to obtain close to asking levels and the market trend is showing, as is usual at this time of year, a firm undertone. Other standard materials saw more interest, but also massive price resistance. Seller hopes for more money might have been thwarted, but sales at steady prices were at least possible.  Interest in sheep and lambskins for double face was quite good and both demand and prices can be expected to be positive for the coming weeks. For nappa types, price is still the determining factor and here the mood was far less optimistic. As already stated, the higher price for bovine hides could be all that is needed to support sheep and lamb in the near future.

For the coming weeks, we believe that different situations will apply to each of the different hide grades.  Male hides should remain reasonably steady with sellers being adequately positioned.  Asking prices may even be increased, but we don’t expect buyers to co-operate so price levels could be more a question of paper rather then a reflection of actual trading. It would not surprise us if cowhides and females traded at marginally lower levels.

We fail to believe that Asian buyers will make up for the missing demand from Europe in the second quarter. However, expectations for sharply reduced prices are likely to be confounded as we believe the imbalance between available inventories and the kill and demand is not wide enough to warrant dramatic price changes. In summary, we believe the existing price range will continue to hold sway, with males being positioned on the higher side of the trading range and females on the lower side.

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