Macroeconomics

Everything on the macroeconomic front has been reasonably quiet over the past few weeks.

Oil prices were driven more by psychological effects rather than fundamental factors. Riots in Nigeria stopped the weaker market trend, but the upcoming end of the winter season in the Northern hemisphere, with high fuel consumption for heating and sufficient stocks should keep prices under control – although the tensions and risks in the Middle East must not be forgotten.

Inflation continues to lurk around the corner. In the USA, consumer prices rose by 4% in January on an annual base. This is also supporting the views of those that are expecting US interest rates to rise further and under present conditions it would not come as a surprise if the Fed raised interest rates once or twice more.

The Japanese economy also delivered good news with a strong performance in the last quarter of 2005. GDP rose by a whopping 5.5 %.

Europe’s performance was again so-so. While optimism is high and although the German IFO index, for example, rose to a 14-year high, the present figures are still only showing steady development and only very optimistic interpretations can see any substantial economic growth.

The US$ remains well supported by interest rates and as the record trade deficit is still lurking in the background, one can only see more dark clouds on the horizon for the US consumer if interest rates rise further. Housing prices remain at worrying levels which could also become a problem.

 

Market intelligence

It appears that we are entering a very interesting period. The tensions between buyers and sellers are growing and consequently the number of forecasts about further market developments is also increasing.

As far as the last two weeks were concerned, the assumptions that we made at the end of the last period proved to be correct.  The market remained in very firm shape and prices continued to advance, even if it was only moderately. The major driving force behind the market development was again China, where tanners have had to make up for the missing orders they didn’t place in December and January when many tanners held off to see the results of the discussions over the import tax that was going to imposed.

At the end of the day Chinese tanners have had to accept that their gamble did not pay off because global demand for raw material easily compensated for their reluctance to buy.  As a result no inventories were built up to burden the market. This means that their hopes for falling prices were quashed and tanners entered the peak production season with insufficient raw material inventories.

What nobody knew was the volume of their needs, and where the main interest would be directed, and in the end they had to buy a lot of European and American dairy cows to cover their existing leather orders and that has driven the market substantially higher.

 

Prices advance

To say substantially higher may be an exaggeration, as in the end prices advanced by a maximum of 5% and this is not really a shocking increase. In the good old days when the market was more influenced by speculation and trading activities, we believe that under the same conditions market prices would have risen much more than that.

Many in the trade, and tanners in particular, are already complaining about ‘high prices’ again. This statement can neither be generalised nor can it be said that this is entirely true. Prices for steers are definitely trading at the upper end of the long term trading range, but nobody can say the same for dairy cows. Neither in Europe nor the United States have the prices for this type of material reached anywhere near the top end of their trading range.  In Europe, in particular, cows can still be bought at around the $50 level and this is more of a ‘no-man’s land’ rather than exceptionally high or low. One should always take this into consideration.

The sentiment that prices are high is definitely related to the downstream calculation prices that we have seen for more than a year now. The price of raw materials was driven purely by the prices retailers were willing to accept from the manufacturers rather than how raw material prices were reflecting the supply and demand balance. Over the past few years there has been an abundant supply of raw material and, with manufacturers fearing that they would not obtain sufficient finished product orders and the influence of the China effect with declining manufacturing costs, led to constantly falling finished product prices. With enough raw material available the potential for prices to move upwards was limited or nonexistent.

This leads us back to the long time cycles which we always try to emphasise in these kinds of reports. Comparing the situation of about a year ago with the situation we are in today might explain the conditions better. When we entered 2005, although this could also be said about 2004, we were already confronted with a relatively uncertain outlook for the global economy and consumer sentiment. The rise of the emerging markets, rising demand for consumer products in these countries, a strong retail market in the United States, and the slow recovery of consumption in Japan all added to a slow but sure improvement in the situation for the basic consumer products around the globe.

This always takes quite a long time until it filters through the supply chain completely. Inventories at all levels of the supply chain need to first be absorbed and manufacturers and suppliers are quite happy to wind down their stocks before they have the courage to ask customers for more money for the product. Even more so considering how drastic an influence price was over the past two years in almost all markets. Cheaper was better, and this was virtually the only argument for business except in the luxury section.

 

Entering a new cycle?

This effect lasted a very long time and we would say that even today not everyone is convinced that we have entered a new period in the cycle.  While during most of 2005 enough raw material was available and the massive price pressure on the supply chain did not allow sellers to increase their prices, the supply situation in the last three to four months has changed completely. Sector by sector the market realised that stocks started to be used up and in some cases they were even exhausted. Instead of reading the warning signs most players were still too busy to look at parts of the market where raw material supply was still sufficient, following the argument that raw material would be continuously sufficient to prevent prices from rising. If it was not the argument of availability, then other factors such as the import tax in China also came into play.  All this goes some way to explain how this situation could have been avoided.

But, at the end of the day, the market has never been decided by what we are thinking but by the realities of supply and demand. The mood for 2006 and all of the economic indications point towards another good year. Orders for leathergoods are coming in at much better levels than expected and this means that leather production is higher on average than people were basically expecting. The variations on the demand side are definitely influencing the situation much more than variations on the supply side.  For bovine hides the total global supply is definitely less than the variation in demand for leather.  Considering that even with steady business in 2005 this sector was able to clean up existing inventories, and as consequently demand exceeded supply, everybody can guess what this will mean for 2006, if the forecasts are met.

 

Cautiously optimistic

We don't, however, just want to paint a positive picture and fuel the fire too much. There is no advantage in driving market prices too much as we all know the consequences.  Leather is still a product that can, in many cases, be substituted and sharply increasing prices for the product would only push manufacturers and designers to reduce the use of leather in their products. We also have to make sure that we do not ignore the possible risks for the development in 2006. Political tensions, bird flu and the vulnerable situation of the US retail market could eventually become a threat and everybody would be well advised to watch out in the very short term for any negative effect that nobody wishes to see at present.

Having said that the opposite situation also needs to be considered. Assuming that 2006 is not affected by any major ‘incidents’ we have to consider that global consumer activity will be moderately stronger than in 2005 and this would increase the imbalance between raw material supply and demand compared with last year.

Markets are never a one-way street either. At the end of the first quarter we have often learned that the market is always at a junction. The change of seasons, a slowdown due to the summer in most parts of the world, an increase in the slaughter – in North America in particular – have had a dampening effect on market development many times before. Under normal circumstances the firm market trend that we have seen for quite some time during the winter should settle and even some setbacks and lower prices would not come as a surprise.

However, this is not really important as the key question is: where is the trend going? Is the average price for the next production season going to be higher than in previous one? This must be more of a driving force behind decisions rather than the question of whether prices might ease slightly next week or the week after.

 

Long term remains important

We received many complaints last year when we took the position that protecting against price rises might be a good idea. We tried to explain that we held this opinion so that raw material prices had a fair chance to move up rather than down looking further ahead and into 2006. Nobody was willing, at the time, to accept that there were good arguments to protect the business by covering as much raw material as possible, although many of the arguments were already visible.

As far as we are concerned, it is time once again to bring the longer term future into focus again and decide on raw material strategy.

The split market also managed to gain some positive momentum from the situation and demand remained steady. Although prices were unable to profit from the situation as much as hides were able to, the split market remains in quite decent shape and it seems that this is going to remain intact until the end of the first quarter at least.

The skin business lost a bit of its pace. This was mainly related to the fact that the seasonal Chinese buying has ended. They are buying a lot for wool purposes and like the product late in the season. The new season in Europe has not really started yet, although the Turkish buyers are already sniffing around for new season lambs. One can be moderately optimistic about the market for the new season as it seems from the recent fair that interest in good quality double face product is good and most inventories from last year have been used up. So, it would come as no surprise if lambskin prices remain on a very solid footing.

 

Firm trend expected

For the coming weeks we still believe that the sentiment will remain firm. Sellers in the main supply markets are pretty well sold up and will not risk exposing themselves to any lower price levels at the moment. The normal reaction in this environment is higher asking levels. On the other hand we have to assume that the key players have now covered their immediate needs and that only some are left chasing the market for more product. This normally brings more traders into play and this is what we have already heard from the market over the last few days. The problem is going to be that any further short term demand is not going to find much availability and this will create problems. The latecomers will have to solve a difficult problem while the market will stay reasonably firm in the short term.