Financial data and statistics did not deliver much news. The economic outlook in Japan has improved and the US economy showed impressive resistance to the consequences of the hurricanes.

The US$ tried to break the annual highs against the euro. It has failed to pass the €1.19 mark for the time being, but levels well above €1.20 are expected. Bulls and bears in the greenback market are still paralysing each other, so that the trend leading up to the end of the year is still not clear.

Germany still hasn’t formed a new government and negotiations for a ‘grand coalition’ are not creating the impression that the country is going to carry out the reforms it would need to get the economy back on track.

Inflation likely to rise

Inflation is now definitely back on the agenda. Consumer prices have risen in the euro zone, as well as in the US and Japan. Further increases in interest rates are likely in the USA, and the ECB has also indicated in recent statements that it is ready for an interest rate hike if it is deemed necessary to keep inflation under control. So, it was made very clear once again that ECB policy still does not consider the economic situation and interest rate levels as a tool to stimulate the economy.

Fortunately, the decline in oil prices has continued and the price per barrel has now fallen back to levels below $60. Despite statements made by those in the industry (obviously many of whom are interested in protecting their current profits as long as possible) we think that there is a fair chance of seeing the trend in oil prices continue to go down rather than up, although the coming winter will support the bulls in the market.

Market intelligence

In the last issues of market intelligence we expressed the opinion that we would need to wait for October to get a clearer picture of what is going to happen after the high level of uncertainty we endured over the summer.

With all of the information we were able to collect over the last weeks; it now seems that we are seeing a major change in the furniture leather business. Over the last two years everyone will agree that there has been one single issue in discussions... price! Everything that was not in the luxury segment had to become cheaper and cheaper and as a consequence quality deteriorated quickly and not only did leather become a complete commodity, even worse it was combined with splits or even PVC to reduce the total price of the sofa.

A question we have raised many times is how far one can go down in quality with a product such as leather when it can then be easily substituted with other materials?  Even worse, if the quality does not meet customers’ expectations it  disqualifies itself for much longer than just the next purchase, and if these thoughts have occurred to the retailers and manufacturers the worst is to be expected. However, something seems to have changed in the trend since the summer holiday break.

Revival in upholstery leather in Northern Italy

Many people we have spoken to are reporting a significant revival in furniture business in Italy.  Raw material suppliers are deeply impressed by the volume of orders they received for hides in September.  At the same time most sellers agree that the market activity from China is underperforming versus a year ago. What seemed to be, at the beginning, just as a temporary market fluctuation has become much more than that over the past few weeks and it seems that this trend could continue for the current season at least. 

With China on holiday for ‘Golden Week’ and maybe having already slowed down the week before it might still be a bit premature to come to a final conclusion. However, one thing that cannot be ignored is the fact that the upholstery tanners in Italy have bought much larger volume of European hides than anybody had expected. What seemed at the beginning of September to just be the replenishment of inventories after the holidays has become a trend and many sellers have confirmed that their bids are already valid for shipments until the end of the year. So, to sum up, at least tanners received many more orders for medium quality furniture leather and this business must have either returned from China or signals that the quality spectrum has moved upwards.

If the latter is the case and the total furniture leather business in China has not declined, it would at least mean that leather business is growing and it is growing in a segment which everyone considered to already be history. 

Is China losing business?

Before celebrating the good news it might be worthwhile analysing the situation as a whole. If the current impression is correct and furniture leather orders have been good for Italy recently, and there is a trend for better quality leather, then one must ask the question as to why this is happening and where the orders are coming from.

The easiest answer would be that China is losing some of the business it thought it had secured in the global market and this volume is floating back to traditional markets. We think that this might be too simple to be the complete reason. Of course some of the leather and also finished furniture buyers have been disappointed with sourcing in China. Many figured out that they do not fit the size criteria to be a fully accepted ‘China buyer’ and to obtain the service and flexibility that they were used to from their traditional suppliers. Many might also have booked excessive quantities in order to have price levels which seemed to be too inviting to refuse. This often led to rebates to in order to sell excess inventory and increased finance costs. Last but not least, the quality might have been disappointing and this may have cost companies not only money but also customers.

Change in demand

This could be one side of the story and would justify a certain return of leather orders back from China to Italy. The second reason could indeed be a change in global demand for leather qualities and smaller individual orders.

But how likely is this to be the case? Looking at the general economic situation, one can find very few reasons why the consumer should suddenly be willing to move away from price as being the main and major driving force. On the other hand why not? Purchasing equipment for your living room is, or should still be, different than buying your weekly essentials. It is still something that you should be really pleased with which will offer pleasure for a longer period of time. Looking at it from an economic standpoint, spending $1,000 more, and assuming you will use the sofa for five years, it only equates to $200 a year.  Yes, it is true that no normal family will look at it this way, but from an emotional standpoint ‘the value for money’ decision can also be made in this situation. Many business theories claim that in more difficult economic times, consumers buy longer lasting products.

Another issue could be the return of inflation. We are now expecting products to become increasingly expensive in the foreseeable future, and therefore you are much more likely to spend now rather than to wait until you may no longer be in the position to afford it. Many of our readers may remember that we have been, and still are, of the opinion that leather prices can only increase when inflation goes up. And as we can see from general economic data and also in the attitudes of central banks there is a very specific fear that a rise in inflation might already be on its way.

Downgrading quality

There is another reason as to why medium quality furniture leather could see a revival. This would come from the exact opposite end of the price structure and would make the above logic totally obsolete. The results, however, would be entirely the same. Here and there you hear that some of the top quality furniture leather makers are not satisfied with their business in 2005 up to now. Consequently, a lot of the demand could be the result of a downgrade in quality in an attempt to reach more economic price levels, even for premium products.

What make this theory less likely is the fact that the volume of this exclusive market segment is much smaller than the size of the increase in demand that Italian tanners seem to have gained recently. Maybe it's also, as is usual, a bit of both.

The consequence for the market, however, is that medium quality dairy cows, in particular, have found their bottom and those sellers who detected a shift in demand early enough had a fair chance to place their productions on a regular base in September. For the moment these seem to be the luckier ones, but it will be interesting to see if the demand for raw material continues to be as brisk as it has been, because then the others will also get their chance, and maybe better prices than today. It still seems to be a bit premature to make a decision, but raw material business was definitely much better than many reports tried to pretend in September.

To give the raw material market any real new direction up to the end of the year there would still have to be a lot of follow-up business and another round of good volume for shipments into 2006. Price resistance still remains very strong and the arguments for a difficult last quarter for consumer products are still fully valid. However, in many sectors of the raw material market, supply is no longer as abundant as it has been and we do not think it would take too much specific demand to increase sellers’ confidence and encourage them to test the market for higher raw material prices.

If this happens we are going to enter a very difficult time, and those tanneries that are not running on a very solid cash flow position will face significant problems. We should never forget either that energy costs, chemical costs in many parts of the world and also waste management costs are substantially higher than they were a year ago.

Demand for goat improves

Whilst we have dealt with the furniture industry in a large part of this report, we should not forget the other sectors and, in particular, leather goods and ladies shoes. Whoever you speak to everybody is confirming that business in these two sectors remains quite good, but unfortunately a lot of the business is focused on smaller skins such as calf and kips. We are already finding some supply shortages, at least in the more economic price ranges, and one can easily see that quite a bit of this demand has already moved into goat skins which have been enjoying increased demand and better prices for sometime now.  We believe that there is good reason to assume that this trend will persist into the first quarter of 2006 at least and everybody would be well-advised to pay attention to raw material procurement for the time being.

The split market also benefited from the generally good condition of the shoe market. Even European suppliers with their lime split products have felt some better demand for splits. Suppliers of good quality drop splits and products which are split in blue have been enjoying a better business climate for a longer period of time now. There is good reason to believe that a better future for the split business can be expected.

Lamb and sheepskins are not yet out of the doldrums completely. However, the shortage of calf and kip and rising prices for goats should eventually spill over into the lamb and sheepskin market. Looking at the new collections of the fashion designers, nappa leather jackets can be seen frequently.  So far they may just be an accessory to the main products, but as a rule when you start seeing them on the catwalk, you tend to find them in the shops one or two seasons later.  Although we do not see garment leather going back to the levels of the 90s, it could well be that the worst is behind us. Prices haven't changed very much but we believe that even here the piled up inventories of raw material have been cleared reasonably well and if we are right about the future it could be that lamb and sheep have seen the bottom of the cycle.

For the coming two weeks we think that the market is still not ready to move. The important leather fair in Italy at the end of October should offer us the final clear idea about the true state of the leather business at present. On top of that, we will be able to see where the fashion trends are heading and hear opinions from a melting pot of sources at the meeting, which will give the trade a clearer picture about what we should expect in the winter season. We still believe that there is good reason to be positive about the future for the leather business, for this season at least. We have had difficult times and the restructuring process has definitely not ended yet, but there is good reason to believe that the worst might be over and consequently everybody would be well-advised to make sure that the whole business set up from procurement to sales is safely planned and covered.

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