Macroeconomics

Statistical data released in the last two weeks delivered no news of any outstanding changes in the general overview.

America’s GDP was revised to 3.9 % versus an initial forecast of 3.7 % for the last quarter of 2004. Inflation in Europe remains under control with the rate at 2.0 % for February. In the USA, inflation is more of a problem with the January rate climbing to 2.3 %.

Financial markets remain sceptical about the economic outlook; because in most regions the long term interest rates look likely to remain low, well below the short term figures.

Europe is still failing to produce any good news. In Germany unemployment figures have risen to new records. Many are blaming this on the new labour market reforms and the statistical effects of this, but whichever way you view it, unemployment figures above five million is worrying for a key economy in Europe. In addition to this, the business climate index for February also fell. Italy did not do much better and so only the peripheral economies are staying on a more positive path.

The US$ continued to trade well above the 1.30 mark and any rallies were only short-lived. Although the USA and Europe are growing at a completely different speed and many indexes consider the US$ to be fairly undervalued, financial markets are still affected by the US deficits and are betting against the greenback.

In our opinion, the recent sharp increase in oil prices is the most interesting news at present. There is no question that this substantial increase will also have a strong effect on the price of finished products. Even though many believe that the influence of energy costs in the production of many products has declined the effect of higher oil prices on family budgets and on the cost of transportation should not be underestimated –the long term effects on inflation must also be considered.

Many pretend that the massive price competition for consumer prices will keep inflation under control, but sooner or later the simple rules of costing will also apply and can no longer be compensated by cheaper labour and competition between producers.

Market intelligence

The past two weeks did still not deliver the clear indications we and many others were hoping for, to get a clear picture of the trend going into the second quarter of 2005.

The main problem for us as publishers of the market intelligence report remains that clear trends are no longer indicated. The continuing fragmentation of individual market sectors makes it more and more difficult to analyse and forecast general trends. One could even say there hasn't been any real trend for quite some time.

The little insight one can get from the activity of recent weeks is again the confirmation that we see an ongoing shift of the leather business from upholstery towards shoe and leather accessories. The very grim sales figures from the two biggest American car manufacturers in the first two months of 2005 have clearly stated again that for the moment, at least, strong growth in car upholstery leather cannot be expected and that the strong pressure on margins in the car industry will definitely be reflected in leather suppliers’ financial results. As a first step, and this is also confirmed by many of the players in the industry, the car industry is looking for cheaper product. As a result as we already noticed in the second half of 2004, many large suppliers of automotive leather started to downgrade their raw material and to use cheaper and more economical origins. The European hide suppliers, and in part also the Americans, were affected the most by this development, because they have been long been the key sources for the production of medium higher quality automotive leather. The Europeans have probably suffered the most, because they not only have to compensate for the pressure on general prices, but also for the sharp decline in the value of the US$.

At the end of the day, this trend is not only touching upholstery, but also the shoe sector.  With the only difference being that shoe tanners are much more accustomed to changes in fashion and as a consequence, accustomed to changes in production and sources of raw materials.  So, what is now happening is that a fundamental shift in upholstery leathers is occurring that brings about a situation that used to be limited to the shoe sector.

Trading and business activity over the last two weeks have definitely shown some improvement. Chinese tanners, in particular, returned to the market and bought reasonable quantities from their regular suppliers. Many people in the trade confirmed that the speed of shipments and the arrival of letter of credits have also improved substantially. This means that old contracts are being honoured more quickly and where suppliers had to push for letter of credits, they are now pushed for quick shipments when the letter of credits are opened. Many think that this is already a clear sign that the low season for the leather business could be over and that the torpor of the past six to eight months could have   n  passed.

However, we would definitely not go that far. We believe that the present activity is nothing more than the normal seasonal reaction following the holiday season and a period of de-stocking in many tanneries. Asian upholstery tanners, in particular, who have gone through a pretty rough time, did not buy or take regular shipments for quite some time. The large production overcapacity in this market has already been mentioned several times and it needed correction after the hype of the first half of 2004.  In the meantime, at least something in the tanning industry has been sorted out and in China the successful ones are separating from the less successful ones. Those with a stable customer base are seeing their regular customers returning despite arguments over prices and they are gaining confidence in their business future.  What they are still not  doing is carrying large raw material inventories and also in the Far East the policy of low stock and just-in-time deliveries has become pretty popular.  Gambling on the raw material market, buying positions, or simply the idea of carrying an ongoing inventory position of several months has become much less commonplace.

No great surprise there, as there has been hardly any need for a long time to buy and own raw materials as a protection against market risk.

There have even been some examples of large tanneries in China that had to change their raw material supply quickly during 2004, because their customers expected different leathers (mainly cheaper ones) very quickly and some tanners had to pull out of their regular supply markets and move to other ones. This has even created situations where existing contracts were not even honoured, because buyers considered the damage caused by losing their reputation to be less than respecting their commitments and taking the loss from not fulfilling their existing contractual commitments.

With almost no risk deriving from the raw material markets, many tanners across the world are becoming more convinced that the demand side has finally taken over control of raw material prices.  This opinion might be supported by the price trends that we have seen over the past years, but it is less the command of demand and much more a change in the supply structure and the improvement of tanning technology that is to thank for this. This is not to speak of the acceptance of less natural products and price becoming the dominating factor for most consumer products.

The fact is that the market demand for low prices was almost synchronised by a shift of beef production.  While South America is increasing production, the western world's production has declined not only because of price, but also as a result of BSE. Cheaper hides became available and met an increasing demand for cheaper and more economical raw materials. At present tensions are growing. With the attempts to continue to lower leather and raw material prices, development has come to a critical point.  While raw material prices have no lower limit, in theory, production costs have gone up and the margins of many leather producers in the world  have been squeezed dramatically. The ratio between production and raw material costs has significantly changed.

While most retailers and brand names, for shoes in particular, are highly profitable, manufacturers are frequently suffering. Only some huge operations can protect themselves and generate adequate margins. Most of the others are confronted with an ever-repeated request for price reductions which in many cases cannot be met by an equivalent fall in raw material prices. Although raw material prices in US$ terms do not look particularly cheap, production costs and transportation for low price sources have already reached critical levels.

The crux of the problem has been addressed by producing semi-finished products at the source, selling the lower selections in good volume at a very cheap price in the hope of getting the compensation needed to cover the raw material price from the average and higher selections. Looking at the inventories and stocks which are available today in many tanneries where medium to low price raw materials are tanned and marketed, one figures out that the dream of achieving top prices for premium product has not been realised and many tanneries are sitting on average and higher selections at a cost price which is today unobtainable in the market. At the same time they have had no trouble moving lower selections in good volume, but never at a price that was sufficient to cover the total calculation. So, at the end of the day, the ratio between quality and price no longer  correlate and to keep production running, the focus was more on maintaining volume and hoping that demand for average selection and prices return in the future.

The question remains to be answered as to whether the demand side will continue to control the trend of the raw material market. In the short term, it seems that we have very little hope. For the time being, we can only expect what we have seen  many times in the past. One sector is taking much more advantage of the raw material price depression than others; the positive trend seen in the car upholstery industry in the 90s and early into this millennium is now evident in the shoe industry, or better said the brand names are enjoying very satisfying operating results. The other extreme is definitely at present the garment and the low price upholstery leather industry.  Both of these sectors are facing very low finished product prices and are still coming under massive pressure to lower levels yet further.  Not only that, but margins squeezed business volume is too low and this is just accelerating and deepening the trend and the problem.

The shoe industry cannot solve the problem alone and we reiterate our opinion that a real turnaround and an upward price trend has to go along with an increase in inflation. This will not exclude a certain price fluctuation like we saw the last year, but the volatility and the extent of price movements will definitely be less than we have seen in the past.  It would require a very intensive external effect or a completely new evaluation of natural products to escape this temporary trap.

The split market also did not perform particularly well.  Many sellers complained of low prices and very severe quality specifications that are sometimes difficult to meet. The hope that some of the good business from the shoe industry would spill over into the split market has, at least for the moment, failed to materialise. Fashion is against it in the main driving force, the ladies shoe sector, which is currently  looking for more quality leathers. However, if the current season is going to succeed, sooner or later the split will regain its position as the cheaper alternative and leather business for splits should not be too far away. An early indication of this should be evident at the Hong Kong leather fair and the GDS shoe show, which will take place within the next four weeks.

The skin market also remains in a difficult state. The problems in the Russian market are still weighing heavily on business in Turkey, China and Poland. The garment season for double face has almost been a non-event. Tanneries in the countries listed above have, in many cases, reduced production, gone idle, or even shut down completely.  Inventories of raw materials and also semi-finished products are quite high in the pipeline. Top quality skins, although slow-moving, have found a reasonable market and cheap raw material is still finding a home at the moment, however,  average quality skins are piling up over. There are still plenty of skins left over from the Muslim festivals and it will take some time for the market to digest the stocks which have been carried over.

For the coming weeks we are probably a bit more optimistic for the bovine sector than we sound above. However, we do not believe that this will be reflected in substantial price rises, just that  business will get marginally better and probably more regular when compared to the period November to February. One will get a clearer view of the typical activity of traders when it gets closer to their trips to Asia and to the Hong Kong Leather Fair. They generally like to own some product to have something to physically sell when they reach their customers’ desks or meet them during the show. This might give one or the other the impression that business is better.  However, we don't believe that the leather business in general is justifying a strong revitalisation of the raw material market and prices as yet. As a result of this, maybe asking prices or official price lists may be a little embellished, but we would be surprised if there is a substantial change in the price structure in the coming weeks or maybe even by the end of this month. 

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