Macroeconomics

The financial world has been almost completely dominated by the political tensions between the USA and Iran. Apart from the political issues involved this has added to the concerns in the oil market and the price per barrel shot straight up into the mid 70s in US dollars.

Stock markets have not taken too much notice as yet and remained slightly firmer or at least steady as a result of the healthy profits reported by large companies around the globe. However, the number of people in the financial community voicing concerns for the second half of 2006 is increasing.

Inflation continues to rise with the US figure now reaching 3.4% against a year ago. Although the market welcomed a narrowing of the trade deficit which was a $2.8 billion less than a month ago, the current figure of $65.7 billion remains frightening enough.

Commodities, and in particular metals, have been setting new records. The $ lost almost 2% against the euro in a single day last week and the widely expected retreat of the US currency is following an orderly pattern when looking at the graphs.

Market intelligence

The past two weeks ended with the leather show in Bologna, Italy. This is also the traditional end to the run of leather shows held in the first half of the year and was basically the last chance for the trade to evaluate the situation of the leather pipeline before the slowdown in production over summer.

Demand remains strong

There was a clear position amongst the trade. Leather demand remains strong into the summer and a number of tanneries still have not covered all of their needs for the run up to their vacations. As a consequence raw material trading and selling was again quite easy and many sellers were surprised in a positive way that whatever stock they still had available was quickly snapped up by their customers.  As a consequence raw material prices remained more than solid and in many cases even advanced incrementally.

What was really evident, however, was the fact that the tanners’ usual complaints about raw material prices were nowhere to be heard. The normal reaction to a market such as this is one of complaints and every second sentence usually starts with, We are losing money..”.  There was none of that this time, and of course there are various interpretations of such a situation. The easiest, and what most sellers are saying, is of course that tanners have very good margins and consequently have no reason to complain about rising raw material prices. More realistically one has to assume that tanners have had much better orders and production levels  since last summer and the higher levels have made the calculations look better.  However, market prices started to accelerate after February this year and one can only assume that, with the present levels that we have now reached, the level of profitability in the leather industry is no longer what it should be.

As for many tanners this problem only arose during a small part of the last season and they are quite happy to make an average calculation. As a result one has to conclude that in general the leather industry is not unhappy about overall performance in the 2005/2006 season. And, looking back exactly one year ago, most of the trade was extremely concerned about the demand and development for the rest of 2005 and the first half of 2006. So, it turned out much better in general and this means that people are happier and more satisfied. European tanners, in particular, are already drawing the bottom line on the season and many of them are now beginning to see problems on the horizon. However, they have obviously decided not bother about it too much for the moment and will start to really worry again after the summer holidays.

Another reason might also be a pretty obvious one, that complaining about business would not change anything. The raw material suppliers are so comfortably sold forward that complaining about leather business is no longer a useful tool with which to open successful negotiations for raw material supplies. In a tight situation, it is more a matter of giving the supplier a good impression of the business situation and not letting him search for many alternatives where he might get a better price because a colleague is short of raw material.

What a change in the market. And we cannot remember having had a similar situation for quite a long time since the serious situation after the first outbreak of mad cow disease some years ago.

So, under normal circumstances one could wind down now and take things easy getting ready to enjoy a long summer vacation and return to business when things are fully clear again. Unfortunately, this is not possible as people need to analyse the current situation in order to forecast how things could develop, and businesses have to make important decisions on how to handle the future.

As we do not have to consider the economics of the situation from a commercial point of view, it might be a little easier for us to analyse the facts and draw some conclusions.

Analysing the prospects

There are a couple of things that have to be taken into consideration. In a market situation such as this, normally prices should really shoot up much more than they have done over the last few weeks and months. Despite all of the complaints raw material prices have only increased incrementally and in very few cases the price rise has exceeded more than 10%  during the season.  Only a few niches in specialities were able to move significantly higher.

Obviously many suppliers have noticed that the leather pipeline operates within different parameters than many other raw material markets. The main reason why things have stayed reasonably stable was definitely the situation of high inventories in the first six months of 2005. So the levels of stock throughout the pipeline and around the globe had to be cleared first before anyone really had the courage to ask more for their product as they were still affected by the difficult time that they had had in placing raw material at the right price from 2003 to 2005. During this period buyers obviously had constant control of the market and every attempt to raise prices was easily fought off.

Due to a higher level of transparency and closer relationships a deeper and more trusting understanding has developed between suppliers and buyers.  Many of the suppliers have also understood that leather cannot be compared with other materials depending on raw material supply.  Metals, energy and other resources have many more opportunities to increase in price, because they cannot be easily substituted on demand.

While the supply side in leather-related raw materials cannot really be influenced, the demand side can. The use of leather can still be reduced simply by a change in fashion or through substituting leather as a material. This does not happen so much during a season, but it is most definitely possible when the seasons change and everyone in the leather pipeline has fulfilled their requirements to a level where buyers can refrain from buying for a certain period of time. Since more and more business today is done directly with the meat producer or the leather manufacturer, the influence of speculation and the intention to hold inventory has declined significantly.  Product flow as far as a by-product of beef production is concerned is one of the major issues of beef producers. Many of them remember only too well what has happened in the past when they have got too greedy over prices and have suddenly run up against a brick wall. This has led to demand drying up and as a consequence existing contracts and planned shipments going up in smoke, and it always takes quite a long time for this to be sorted out, not only as far as prices are concerned but also in terms of the normal and regular product flow being re-established.

This must be one of the reasons why players in this market might have kept price developments under tight control and that they were much more interested in extending their forward sales position at acceptable price levels rather than risking pushing things too far ahead only to suffer the consequences they have experienced in the past.

A change in philosophy

Buyers also noted the change in philosophy and this kind of security and confidence enabled them to also make longer term commitments and plan higher volumes with their customers, which have been rising nicely as a result of the healthy state of the global economy and the rising demand for leather products.

However, we are now at a junction because raw material inventories have been depleted so there is now no security buffer available to cushion any further positive developments in leather demand. Consequently, the leather pipeline must now make a fundamental decision over whether price levels can be lifted for the 2006/2007 season or if the demand for leather products would fade quickly if prices rise any further.

If what we said earlier about this is correct—if the supply side were not to change very much and additional availabilities in the form of stock are no longer available to meet further increasing leather demand or maybe not even support the existing level of leather demand—then something has to happen on the demand side. Many people in the trade believe that from a logical perspective the demand for leather as such is going to decline. But this is not necessarily the case. As some people have mentioned to us, we already have the chance to spread the use of leather into a higher number of products simply by changing the designs and fashion. When we consider that we are now moving into the third season where knee high ladies’ boots are in fashion, which consume almost three  times the amount of leather than a normal pair of shoes requires, one can already see how much can be done just by a change in fashion. Not to mention the possibility of substituting leather with alternatives and not only non-leather alternatives. 

If you look at the raw material supply and prices there are still plenty of raw materials, in particular lamb and goat for the shoe industry, which are still in abundant supply at historically low prices, where sellers are seriously struggling to move their product to buyers. We have already spoken about the different segments of the leather business and since normal garments made of leather are still not moving very well or in high volumes, there is still a high availability of raw material in these segments whereas the classical bovine related raw material is becoming shorter and shorter. Consequently tanners have carried out a lot of sampling and experiments, the results of which were shown at the fair in Bologna. It is probably adequate to say that one can only hope there's going to be a positive response from the leather manufacturers to the creativity of their suppliers. Also they have to understand that they are dependent on a limited supply of specific raw materials and that they must leave their suppliers with the freedom to solve this particular problem through their capabilities. They cannot just sit around complaining about product prices without seriously discussing how the problem can be solved to the mutual benefit of both parties.

Looking at the present status of the industry and the situation in the supply chain, the often repeated theory that all of the demand and firmness was only related to the Chinese market buying because of the new VAT regulations cannot be maintained. As a consequence the prediction of many in the industry was that the market would adjust sharply by the end of June at the latest. However, it is now clear that it is a simple case that there was, and still is, more demand and this will not allow the raw material market to react in a way that many believe would be logical.

Although the situation as a whole is convincing, one still has to piece together all of the arguments and we have learnt from the past that timing is much more important than the simple rules of supply and demand. So, it might be time once more to move away from the day-to-day business a little and look into the crystal ball again. As a general rule it is too early in April and the next in-depth analysis is only due in the summer, but it might be advisable to collect some facts already. Let’s try to make a simple pros and cons list for the market development and draw some conclusions at the end:

Pros

• After strong and healthy demand the supply chain has used up most inventories of raw material and supply will not meet demand if production and demand stay steady for the next season, not to mention any possible additional increase.
• Global sales for shoes have been exceptionally good in this last season. A cold winter in many areas has also cleaned out inventories. Retailers need to replenish their stocks and are likely to take a positive outlook for the future after good clearance in the previous season.
• Strong growth continues in the emerging markets which also represent large populations. Rising personal income is supporting demand for affordable consumer products.
• Fashion is promoting leather again and manufacturers and retailers prefer volumes with reduced gross margins due to higher cost prices rather than decisions to walk away from sales potentials as a matter of budget doctrines.

Cons

• Rising prices for raw material and components make leather products more expensive and manufacturers could decide to keep finished product prices under control by substituting or reducing the leather content.
• Rising energy prices, interest rates and a slow down of the US economy in the second half of the year may burden consumer spending and demand and sales might not meet forecasts and budgets.
• Rising energy prices, in particular for heating oil and petrol, may weigh on sales for big tickets items and the demand for cars and upholstery could drop significantly.
• The increased price for oil and other commodities may lead to increasing inflationary pressure with the consequence of further rising interest rates and falling stock markets.
• Political tensions related to the problems in the Middle East and general disagreements over economic policies between the big blocs could trigger further political and economic decisions that hinder the free flow of products and hinder global trade.
• Leather product manufacturers may discover the beauty of other leather alternatives such as goat, hairsheep and lamb/sheep and the access and use of raw materials with good and available resources could lift a lot of pressure from the markets that performed strongly of the last season.
• The strong performance of the Chinese market may have been simply related to the change in the VAT policy and speculation on a revaluation of the RNB. Tanners may be facing an opposite situation versus 2006 and hold extended inventories of raw material which could reduce raw material demand significantly in Q3 of 2006.
• Tanners may suffer from profitability problems and an increasing number could also find themselves squeezed in cash situations. As a consequence it could be decided that soakings have to be cut for individual reasons.

We have to admit that we find the cons rather more convincing than the pros. It is not just the mere number of arguments, but the weight and probability which we find more likely to happen rather than a simple extension of the existing situation.

However, there is certainly no immediate risk for the market or the performance of the leather pipeline. It is just an attempt to analyse the medium- to long-term trends and to deliver the risk and chance balance for the decisions which have to be made by individual companies, and the interpretation by individual enterprises and situations also differ.

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