Macroeconomics

The world is trying to get back into the normal gear after the summer break in the western world.

There has been little information from the financial markets so far. Oil prices bounced up and down and remain very susceptible to speculation and news from the terrorist front. As a consequence, the average level remains far above $45 dollars and, despite the opinion of many economists, there are growing concerns about the cost of products and transport in the business world.  We believe that, if the predictions of oil prices staying high for some time are right, the effects on consumer spending will be much higher than many anticipate today.  The influence on the general economy does, however, generally come with a six to 12-month delay.

The currency markets remained within the trading band we have now seen for almost a month. The dollar-euro exchange rate fluctuated by 1 - 2 cents.

Good news came from the unemployment figures in the USA last Friday. The number of new jobs created rose above analysts’ expectations and delivered hope as they will compensate for the downturn in consumer confidence.  We always have to understand that the US economy is based in two thirds on private consumption and on the automotive industry for the global economy.

The automotive industry brought bad news. Car sales in the USA dropped substantially in August and China had to admit that car sales have not been as high as expected. Chinese media reported unsold inventories of new cars rise to 300.000 units at the end of August. At the same time, an international discussion about the general overcapacity in the automotive production commenced, with General Motors considering the shutdown of one of its European plants to reduce manufacturing and prevent further unsold inventories. This cannot have been good news for the automotive leather producers. Even if penetration of leather compensated for the reduction in production, we must bear in mind that, after the golden years of automotive leather production, price pressure and production problems may hit the sector earlier than we think.

Market intelligence

There were hardly any sales of interest other than the leather fair in Shanghai in the past two weeks. The main European tanning centres only returned to work about a week ago and busied themselves resuming productions and sorting out piles of paper which has accumulated on desks in the weeks of holidays.

Many, if not most, American hide suppliers were already travelling for more than a week in Asia and some of them will continue their trips in the coming weektoo.  European visitors came predominantly to the show only, as many of them seemed to have travelled before their July holidays.

Exhibitors and visitors were impressed by the attendance.  Many anticipated some years ago that Shanghai it would eventually beat the importance of APLF in Hong Kong.  We do not share the view as the timing of the two fairs is completely different as is the function of the events. While Hong Kong is a more global marketplace with many more international exhibitors, Shanghai is a more domestic Chinese event, particularly for the upholstery market. What could eventually become a problem is attracting enough exhibitors for both events to make them a commercial success. We heard from various chemical companies that they plan to exclude the Hong Kong fair from their itineraries and focus just on Shanghai. Yet for the next year or two things will most likely remain unchanged.

Many were hoping that the Shanghai get-together would help with decisions which need to be taken for the coming season. It did and it did not. The main problem is the timing of the show, just too early after the summer break.  Europe has not picked up again after the holidays, the American retailers and buyers of leather or leather products have not yet delivered their final decisions and things look quiet in the domestic Chinese market despite it being September. The only market which should already be delivering clearer indicators is the sector of garment leather which will start early this season with first orders from Russia. Garment tanners and, in particular, those turning the skins have been the most precise in their buying interest and designs.  However, there was again the difficulty of finding a raw material which fits into the price range of finished leather or jackets that the market is willing to pay for at the time. Furniture tanners are also very clear that their problem does not lie in the volume of orders but only in buying a raw material for a price which leaves a profit in production.

This problem, which we have now faced for quite some time, needs more analysis and we have to consider possible scenarios for the forthcoming weeks when final decisions are made. One other obvious thing is that tanners need to replenish their inventories in the second half of September and will need a shipment of raw material reasonably quickly.  At present they are still quite comfortable, as the low production summer season and the financial bottlenecks many of the tanners are facing in China have left them with enough inventories in their warehouses and outstanding contracts.

However, the new production season will take off very soon and has not only the problem of fitting raw material prices but also having a long-term effect on leather contracts with raw materials at an adequate price level. When, at the beginning of this season, calculations were already sold tight it was never likely that any increase in raw material prices could jeopardize the whole profitability of the seasonal contract.  In general, the first three to four months of production should be safely calculated and generate an economical much.  History has very often proven that prices for raw material tend to be on average higher than the price level at the beginning of September.  Since tanners also know this fact, they are trying to bring the market down by another five to 10% to start the production season at levels which are safe and profitable. The next weeks will prove if they are going to be successful or not, but we believe that more than just small adjustments can be expected.

The main reason for that is the rising overcapacity, particularly in China.  Not only the existing facilities are already too big in our view but further expansion programmes and new factories will add to the existing ones next year. The consequences are all too obvious: increasing raw material prices and decreasing finished product prices.

We would, therefore, need either a strong variation of the raw material supply or a sharp decline in the demand for consumer products for a major change in the trend of raw material costs.  Despite the ongoing discussion about the future trend of the global economy, we believe that neither of the two options can be realistically expected for the rest of this year.  Consequently, we are left with the other option - problems deriving from the financial markets.

Meetings in Shanghai, including bankers, confirmed that the tightening of credit facilities used by the Chinese government to slowdown the growth of the economy is working. Suppliers of raw materials delivering to domestic Chinese tanning operations are all reporting requests of extended payment deadlines to 120 and even 180 days. Even when payment is effected by a letter of credits and when, as it is in most cases, commercial banks in America or Europe are willing to confirm the same, we have to be aware that the Chinese banks and government shift part of the risk outside the country, binding the international financial community tightly into the finance and risk of the economy.

This problem is, however, limited to domestic operations while most joint-venture companies dispose of enough working capital so that this problem does not apply to them.

As mentioned already, the biggest threat to the present situation in the upholstery business is the existing and increasing overcapacity in production. This problem is also recognised by the Chinese tanneries today which, until not very long ago, were still of the opinion that the market growth in China and the advantage of cost would cover an endless room for production expansion.  Now they have had to learn that, like in many other businesses, expansion of production capacity has been too quick and too fast.  Those tanneries end furniture manufacturers will have grown mainly on export business. Whilst they experience a lot of price competition, they certainly have more security for production and sales than their counterparts, who are mainly producing for the domestic market.  The financial aspect here is also quite important.  While exporting countries dispose of the much more regular and safe money returns, largely based on credits, their cash flow management is much easier for the tanneries selling domestically.  The financial system in domestic China is still based very much on credits relation, not using ordinary commercial payment transactions through banks. If they had the same time to buy, schedule and finance imports against the dollar, their cash flow management would be far more complicated.

In the side leather business the situation is quite similar. The big international export business is mainly controlled by large joint-venture companies, particularly with roots in Taiwan.  Since these are mainly large production units their business is mostly based on long-term arrangements on both sides.  This means that supplying companies, mainly from the USA and South America, are integrated into long-term supply chain calculations.  As already explained in one of our previous versions of the market intelligence, the key players in the supply chain are particularly interested in price stability, despite their interest to obtain best revenues or to buy the cheapest price.  Consequently, a lot of raw materials which are predominantly used in this sector do not reach the ‘free market’ anymore.  Price records and quotations today cover a relatively small part of the market, left to the few remaining independent players.

We have to assume that the present price range for the main steer types, present for at least the last six months, only excludes the eruption during the BSE period, which suits most interested parties in the supply chain. The situation for producers mainly supplying the domestic Chinese market is a bit different.  Massive price pressure has also arrived in China and producers are looking for cheaper and cheaper raw material to meet the price targets of the market.  The consequence is that they are downgrading the quality of the raw material all the time. Some can be improved by better production and finishing technologies and some by fashion.  However, a bad quality hide is always a bad quality hide and impinges on the finished product.

In side leather business we notice a lot more interest in raw materials form India and Pakistan. This is confirming the trade rumours that more fashion and dress shoes are ordered from the market, as well as higher quality leather types in lighter weight categories. It well may be that shoe buyers and retailers do not want to have all eggs in one Chinese basket and have shifted some operations back to their traditional buyers for reasons of fashion and competence. We will follow these rumours with intense interest to see whether there carry much substance.

What do we make out of all this? When we summarise the situation and the results from trips to Asia we come to the following conclusions:

We have the confirmation that no manufacturer is concerned about the volume of orders expected from the coming season

Almost every seller and buyer is convinced that the present price band continues to be intact for a long time ahead.  This means that buyers are convinced that they will always have the chance to buy and the low side sellers are sure to sell on the high side, making prices less and less elastic.

Looking at this superficially, the situation seems to be quite comfortable for everyone, considering the price range is only five to 10% from the low to the high. Tanners admit that they can operate profitably at the low level, while sellers can be comfortable with the high levels. Since both sides passed by various times in the last season, buyers and sellers have positioned themselves comfortably and believe that they just have to wait until it is their turn again. Basically, everyone expects the same situation in the coming season and one can easily recognise that most players have positioned themselves accordingly. We see a dangerous factor in this behaviour.

The more people follow this trend and feel comfortable the more volatile and sensible to change the market becomes. The system works only when supply and demand remain in a balance similar to that seen for the past year. In normal market conditions players are always on a high alert as far as news, changes and external influences are concerned. We believe that the attention is far reduced now, the risk management in particular, with tanners and manufacturers not acknowledging the fact that raw material prices could at some stage react differently.

Just to clarify the situation, at present we believe that the supply chain is well controlled by the retailers and the prices on the consumer markets. However, having spoken about large overcapacities, raw material prices would react strongly to an increase in demand. The leverage in such a situation would be intense. At the moment the leverage is less because excessive capacities find lower raw material prices more attractive for their productions and easier in terms of risk, as they prefer to buy rather than to bear unused production space. This applies especially when contracts are already signed and tanners have to deliver against them.

As for sellers we would like to mention that the market also has a strong short-term reaction against variations on the supply side. The effect of using free production space due to more attractive raw material price has always had a significant time lag. Hence, only those sellers who can afford to think and operate (warehouse and financial resources) in long-term cycles have the chance to protect themselves and operate accordingly.

The sheep and lambskin market is quite stable. Despite increased interest we expect in skins in the garment sector, due to the high prices for garment related hides, we still have no evidence that larger bookings have been made. Double face buyers in Turkey were present in the background but most sellers confirm that there is still a small gap between the two. The situation for nappa skins is similar. Seasonal slaughter is starting in some of the regions of Northern Europe but farmers and slaughterhouses are still missing clear indicators of price levels they will be paying. Many find it difficult to understand the lower bids which are mainly related to the weaker dollar against the prices they obtained a year ago. We may recall the dollar is about 25 % lower today. We do think, however, that in the next week business for skins will pick up and we would not be surprised if prices fell by a fraction before sellers are able to move whatever they need to clean up productions before the end of the year.

The split market was definitely somewhat weaker. It may not have been a lot but, despite the strong interest for low price material, the hype for splits is cooling off. If the news is correct the interest on side leather is changing to higher quality items, so a reduction in interest would not be a surprise. However, how the request for lower prices fits into the trend for better quality leathers will remain a secret of the designers and shoe companies.

What is the outlook now? With rising kills, particularly in Europe, and the assumption that the next round of buying will not take place before the end of the month, we would not be surprised to see moderate pressure on the market and prices. This applies more to cows than steers and bulls because cows are valued higher. However, we should not see a desperate seller at least in the coming weeks. A certain risk derives from the question of how many L/Cs are opened with delay, as further accumulation of sold but untaken hides could quickly change the mind of the sellers. Perhaps some discounts have already been made from the official price lists and, if they are eventually published, it could be the adjustment we are expect in the short term. For sharper corrections the business outlook remains good as long as the market is not influenced by the financial markets.

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