Macroeconomics

A few more meaningful indicators for the future were received from the financial markets during the period under review (June 28-July 12).

The US labour market delivered disappointing results, at least disappointing for the financial markets which tend to base their conclusions around their expectations, not the realities of the 'here and now'.

No matter, as the US economy has added a fair number of new jobs in the last year, even if this very moderate shortfall in expectations dampened analyst sentiment. Rising fears about terrorism and higher oil prices added to the downbeat mood. As a consequence, the markets began to lower the value of the dollar which broke out of its long established trading range, finishing against the € at around 1.24 and against the Japanese Yen at 108.

There is an increasing risk that the dollar could be on the brink of another rapid decline if the present trend is not halted soon. This would certainly propel the Greenback to new lows vs. the other main world currencies. We can only recommend again keeping a close eye on the markets over the vacation period.

Discussions about rising inflation continue to be frequently mentioned in the media, an issue which we have already focussed on.  The economies of Europe and Japan showed further signs of recovery, but the situation remains pretty fragile. Because of Japan's high dependency on the economies of China, the USA and Europe, the currency factor could quickly become critical again for the Yen. Suffice to say that while commodity exporting countries are continuing to enjoy healthy returns on oil, metal and other raw materials, these can be expected to push finished product prices higher.

China's action to control its economic growth is now having the desired effect by slowing consumer demand and investment. This can especially be seen in the reduction in demand for cars, and reports of record inventories are now coming to light. Other sectors such as real estate and machinery are feeling the restricted access to capital. One can only hope that the action of the government does not create an implosion in the economy, as seen in Japan and the other Asian countries in the '90s, but officials continue to assert that they cannot see any reason for this to happen. Regardless, one is well advised to keep an eye on developments in this area.

An increase of global inflation and/or a setback in the US economy would also hit the Chinese economy hard, despite the domestic growth potential. Similarly, a rise in the price of imported raw materials would increase the need for finance, a situation which in turn could create a nightmare for undercapitalised companies, including those involved in the production of leather. 

Market Intelligence

Given the subdued nature of market activity during the season, the summer versions of MI (including this) will either be shorter or deal with issues of a more general nature. The trend for moderately rising hide prices continued. This was in spite of all cautious reports and attempts made by many market players to talk down the underlying strength of raw material prices. One cannot get away from the fact that average prices are on the rise.

As usual, currency issues continued to play an important role which meant returns and costs were largely dependent on where in the world your business is based. However, the trend in US$ terms - the basis of this analysis - was clearly more positive. This was because demand has been exceeding supply for some time. The extent of the increase was different in the various different markets, but lower price material made the biggest gains.

The question to be answered now is whether or not this trend will continue and if it does, whether will it continue at its current moderate rate or accelerate. This is indeed a tricky question, made all the more difficult to answer by the fact that in Europe we are currently in the holiday season and a great deal of leather contracts will be renegotiated between August and October. So, to know if any success will be achieved in increasing leather prices, we will need to wait to see the volume of orders landing 8-12 weeks from now. In the meantime, we will just try to collect the facts and arguments without drawing any conclusions. We will leave these to later editions of Market Intelligence.

The direction in which leather prices will go notwithstanding, we believe the most important subjects of the moment to be capacity in the leather industry and how it is applied.  In fact, we believe capacity to be the issue that will shape the market's development in coming years.  The whole trade is now wondering if the expansion of  production capacity in Asia and China in particular, coupled with rising production in South America, is expanding faster than the contraction being seen in other parts of the world.  In the past year it seems that the shift of production has been going on in an orderly fashion and there has been enough raw material to satisfy the demand of the total global industry. We have mentioned this before, but we believe that the net demand for raw material has increased. Negative sentiment was largely explained by reduced inventories in the production chain.

The steadier markets and substantially improved flow of material that we are now seeing are not the outcome of oversupply or falling demand, as some in the industry would contend, but rather the result of a greater transparency in market information (leading to less speculation) and improved supply chain management. Likewise, price pressure on finished products coupled the shift to lower cost centres of production has enabled buyers to reduce their purchase price levels. Against this backdrop, it can be seen why we have been so interested in the risk of price increases for some time. In that it is a long term trend, it also now leaves us free to analyse shorter term factors that might influence things during the second half of the year.

We have already explained why over the past few months we have considered the risk of raw material price rises to outweigh the chances of a fall and basically we have been proved right.  Given the success of this approach, let's now explore the scenario where prices fall over the coming months.

Happily, given the current reasonably low state of inventories and steady outlook for the industry as a whole, a scenario of this kind is unlikely. Nevertheless, Beijing's recently-introduced deflationary policy and its reduction in the opportunities businesses have to access capital could spell problems. Chinese leather producers that have expanded rapidly in recent years and which are currently underfinanced would be especially vulnerable. The reduction seen in the flow of payments and letters of credit from this part of the world are only partly explained by seasonal decline. A lot of producers have already had to refinance their businesses and/or find new credit facilities to keep their operations running, leading one to wonder whether their plans for new or increased production will now be realised. Another looming problem is the overcapacity in China. While the rest of the world is already talking about the return of inflation, deflation is still an issue in China. With overcapacity continuing to depress both prices and profits, rising raw material costs would likely spell serious trouble for the industry.

Energy is also a major threat to the Chinese industry, particularly in the summer season. Not only is the cost of energy is rising, but in various parts of the country scheduled power cuts to save energy have already become commonplace. Depending on the temperatures, issues of energy could have a major bearing on levels of production and demand in the coming weeks.

The Chinese domestic market cannot be relied upon to expand steadily and forever. While producers of normal leather products such as shoes are still enjoying the fruits of the consumer's increasing spending power, sales of higher ticket items such as automobiles have already begun to suffer. While production climbed 32.4 % in the first half, sales increased by only by 29.4 %. Consequently inventories have risen to more than 140,000 units. Admittedly, Chinese car output is still low with slightly above one million units, as is the use of leather in cars produced there.  However, one should remember that a lot of the growth was based on projections for a steady and massive rise in both production and sales. Overproduction in the car industry is one of the hottest issue in the marketplace and while it may not come to pass, in the meantime the fear of it happening could be just as damaging.

Staying with the car industry, sales globally are in the doldrums. Neither the US market with disappointing numbers for June, nor the German market being flat for the year, offered much hope, even if the Japanese and Korean manufacturers continued to enjoy growth and good results. Volkswagen declared last week that its plants in Germany were operating at around 70 % of capacity and a profit warning is now expected by the markets. Automakers may well be painting a positive picture for the rest of the year, but high fuel costs, a glut of new models and overproduction mean the reality is likely to be much less rosy.

One thing is certain. The bonus programmes and rebates that are now established in almost all the key auto markets, and the lower revenues that stem from these, will make it extremely difficult for the world's suppliers of auto leather to maintain their current margins. The best they can hope for is that leather will be used more as a sales tool, but this would not be expensive leather. Consequently there is little good news for leather producers on this front in the medium term.

While not wishing to depress our readers too much before they head off on their holidays, we need to return to the unresolved influences on the US economy of the twin deficit and the Iraq war.  While the problems in the Middle East and terrorism are obvious to everyone who follows the news, they can also be seen at the fuel pump and in the extortionate prices now being asked for winter heating oil. Although we have mentioned it before, the fact remains that high energy costs are a ‘killer’ for private consumption and they are a major driver of inflation.  

Apart from rising cost and prices for everyone, we have also to remember that periods of higher inflation are frequently accompanied by higher raw material costs and here we come back to the fact that hides and skins are one of the few products to have so far escaped the current rising trend. But the likelihood is that they will follow suit. Staying with our inflationary scenario, business costs would also likely rise, as would levels of price competition stemming from manufacturing overcapacity.  It is a problem that economists are only now starting to think about.

Currently, inflation is measured using a basket of consumer prices, but this might not be accurate enough anymore. The basket has changed as telecommunication is today a fixed and increased part of the budget and rising. Mobility (cars) in times of high energy costs also reduce spending resources, as do rising heating, cooling and energy costs.  Capital costs rise as well.

When income fails to keep pace with costs (inflation) and manufacturing capacity exceeds demand (as is currently the case in emerging markets) factory gate prices can become depressed when they should be rising, even in an environment of inflation.  When this occurs, the end result is a rising level of business closures.  At the moment, the markets are still positive and company results in many parts of the world are good.  But this does not erase the risk for the future.  This applies especially to the leather industry where margins are already low. Leather producers in high production cost countries are already encountering the problem, but others could face similar problems soon.

Turning to the US twin deficit, while many companies don’t see this as having any immediate effect on their business, currency issues most certainly do. As we head to the US elections, US policy could quickly change and we leave this to the evaluation of the experts. But the deficit will not go away and can only be resolved by stemming imports, ramping up exports, reducing consumption, increasing taxes and cutting back on public spending. Driving the economy through low interest rates and tax incentives, as is the case now, cannot go on forever and none of the short term counteractions currently being mooted will likely benefit consumer spending or the value of the dollar.

We know these are very controversial statements and there are many who will disagree, but we are prepared to share our opinions and if any of our readers has comments we would be delighted receive and discuss them.

So what have the leather industry sectors been doing in the meantime?  The lamb and sheepskin market has been more difficult recently. The traditional seasonal hype for new season lambskins has now peaked and the spring round of buying is in the process of cooling off. Turkey became more subdued as sellers became more concerned about their sales and shipments over the summer. The high level of prices in the Southern hemisphere and reasonable sales seen during the previous months meant sellers were in no mood to lower their prices, even if they were unable to raise them.  A positive development for skins remained the high price of their alternatives.  This was especially the case with dairy cows, where there was little downward pressure on prices.  Interest in nappa skins remained, but with the competition from pig and split, there remained a price limit on these products.

The split market was no more than steady. Interest for lower priced products kept demand for splits steady, without any chance of increasing prices. The summer season should now start to see reduced offers from Europe and some difficulties in moving gelatine products could emerge. However, we don’t think this will be at all influential so little should change.

Despite the downbeat picture painted in this issue of Market Intelligence, this does not mean a short term reduction in prices and demand. With the reduced offer and availability and the continuing need for tanners to buy - at least in Asia - we fail to see any reason for price reductions in the weeks to come. Tanners will continue to look for bargains and there will continue to be sellers willing to accept bids for different reasons. The search for cheaper alternatives will continue as will their propensity to disappoint those looking for the same levels of quality at the price. Prices will likely remain at present levels with sellers not getting too enthusiastic when considering lower bids.

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