Macroeconomics

 

Two weeks ago, in the macroeconomic section of the report, we mentioned the fact that the financial community was ignoring some of the negative influences occurring in the financial world. This has changed in the past fortnight.

 

Commodity prices, the stock markets, and interest rates have begun to reflect some of the concerns that we have been discussing for some time. Most of the global stock markets fell by five to 10% and commodity prices also had to suffer what could be called a correction.  Many of the pundits are now mulling the classic question of whether to buy, hold, or sell, and as usual, there are plenty of arguments to justify individual convictions or positions.

 

There were also some jitters in the currency market. As soon as the US dollar lost some of its value against other currencies, many began discussing how quickly new lows would be reached. But, as is usual in such environments, what happened was very different to what had been expected. The dollar settled and even managed to gain on previous levels, although, in this particular case, one still has to be quite cautious. It is pretty obvious that the global financial community is still betting strongly against the US currency and even if they are wrong, as they were in 2005, it would be quite dangerous to fight against the tide, in the short-term at least.

 

 

 

Dollar may affect exports

It should, however, not be overlooked that the arguments currently being thrown into the ring about the direction of the US dollar are probably not giving a full picture of the situation.  A lot of this has to do with the conviction that the US economy is going to slowdown in the second half of 2006, whilst Europe and Japan, in particular, are expected to perform better and the rise in interest rates should narrow. This comes on top of all the other problems that the US is facing such as the trade and budget deficits. All of this might be true and this has already led to the devaluation of the US currency, as we had also expected, but nobody should ignore the fact that events in other parts of the world might not have as positive an outcome as the media is trying to depict. So, even if the descent of the US dollar continues, the effect of this on export business in other parts of the world, where domestic consumption is not the driving force behind the economic development, should not be underestimated.

 

In the last issue of market intelligence we focused our attention on the financial markets, and we think that in the analysis of the leather pipeline one would be well-advised to watch the general trend of the global economy during the summer before making decisions on how to conduct business in leather and leather products.

 

The most interesting data to appear in the last two weeks was the decline of commodity prices such as metals, and also oil. They all fell by five to 10% in a week. The US has increased interest rates by another quarter of a per cent already, while in Europe interest rates are still under discussion and everybody is wondering if the European Central bank will also raise interest rates in June. A lot is pointing in that direction.

 

Market intelligence

 

The leather pipeline is currently in the usual low season. In most of the world people are now preparing not only for the summer holidays but also for the football World Cup which will start at the beginning of June in Germany. Although many people are not interested in the sport, it is worth considering that the countries where football has most of its supporters are also the ones where the leather pipeline has strong positions. This applies, in particular, to South America and Europe in total. However, surprisingly enough, football is also gaining more and more popularity and support in China.  As a result of the timing of the games, most of the world will be able to watch the matches on television and despite the fact that no factories will close because of football; it will definitely have an impact on activity around the globe.

 

What has happened in the market in the last two weeks? Not much as far as we can see. We would say that activity is slowing down. The heat is off, despite continuing impressive sales reports from various markets – if they are true.

 

Just how quickly wrong impressions can be created was seen two weeks ago with the reported export sales numbers from the US. A whopping number of wet blue hide sales impressed the trade which later turned out to be pounds of splits and not pieces of hides. What was interesting, however, was that there was little excitement when the original number was published. It seems that the market expects anything these days and after the strong performance of the previous month even numbers over one million pieces do not seem capable of impressing anybody.

 

Sometimes it seems a little like other markets where bubbles are created. The trend is your friend and the general sentiment is accepted however unrealistic as it may seem. Anyway, even the corrected number was still impressive enough and so the US market remained well supported.

 

Market slows down

Despite the statistical activity, we would say the market is in a period of ‘tiring’. Although tiring may not be the right expression to use after the tremendous performance we have seen in this last season. ‘Rolling out’ might be a better description of the reality. The leather season for furniture is coming to an end and in the automotive industry we have a mixture of rolling out models and start up productions. The shoe industry is a little ‘in between’ the seasons and this is definitely the case in the garment business. As a consequence most operations are now taking a break in procurement in order to administer their existing order book.

 

At best, enterprises are now spending their management meetings discussing the future and this is probably the most difficult issue at the moment. Management needs to decide how to handle the price issue of leather for the next season and that means either discussing article ranges with their clients or simply increasing prices without losing too much business. Higher price levels for raw materials, chemicals, wastewater treatments have to be negotiated. In the case of European tanners depending on exports into the US$ zones, the weaker US$ also has to be considered and this will mean at least 2-7% against the previous season.

 

The issue of prices and calculations hasn’t been much of an issue over the past few months and as observers of the leather pipeline we have to admit that we have often asked ourselves why the leather industry complained so little. Well, this may have something to do with the pretty good order situation and the fact that prices and costs only accelerated towards the end of the season and left the industry in a long period of profitable production before calculations were written in red ink.

 

Rising costs cause pressure

Considering now that the vast majority of costs, including raw materials, have significantly increased, their calculations must be pretty difficult now. In a rough estimate, people consider that about 60% to 80% of the cost in the tanning industry have increased by five to 20%. This is, of course, different in different countries as energy, for example, is still greatly subsidised in many regions of this world. When it comes to chemicals and raw materials, then it hits everybody in almost the same way everywhere. And, in Europe we have to add the currency issue as already mentioned before.

 

Basically, only labour costs have remained stable and productivity gains in the industry can hardly be seen to be more than 3% to 5% if that much.

 

So, producers and users of leather must have a tremendous price obstacle to solve. As the extent of the price increase is much more substantial than ever before, it will not be very easy to resolve the matter either. The solution of using cheaper raw materials and to lower the specifications is only a very limited tool and has already been used.  So, at the end of the day the only option remaining is to use less leather and this will finally reduce demand. There is some relief that leather substitutes have also become more expensive due to the rise in oil process and other raw materials. This will definitely not be enough though.

 

So, despite the solid state of the raw material market we have to reiterate our opinion that there is definitely cause for concern for the future of the raw material market.

 

Uncertainty over China

Apart from this general analysis we still have to deal with the big question of whether the strong demand seen from China was in any way related to the custom books or whether it was simply a reflection of the good leather business globally.  At least when it comes to upholstery leather we are quite convinced that a certain amount of speculation was definitely involved in the development and demand in the first months of 2006. And so we believe that the market for upholstery-related hides might be one of the first to see less demand and price pressure.

 

There is one interesting piece of news circulating the leather pipeline at the moment. The Chinese authorities are again investigating customs fraud and there are rumours that another large importer in the South of China is under investigation and may be prosecuted as the volumes and the amount of money involved are really quite spectacular. The rumours state that there are more than 6 billion RNB of imports which have been incorrectly declared. As a consequence most of the Chinese import trade is extremely cautious again and as we know this can always lead to a significant interruption in hide imports. This will not affect the traditional supply markets as here there are only very low volumes making obscure inroads into China, but if it hits other markets it will eventually also influence the traditional ones.

 

 

The general setback in the stock markets and commodity prices could also eventually hit the hide and skin market.  The Asians, and in particular the Chinese, are gamblers by tradition and with commodity prices rising sharply it could well be that part of the reason for the strong demand from Asia is also related to simple raw material and commodity speculation.  Everybody in the trade is wondering whether the volumes that have been bought and shipped were really just coverage of raw material needs for leather production. We can still not exclude that but there is a fair chance that part of the buying was also a speculative issue. As sensitive as commodity markets can be, and they are particularly so in the hide and skin market, it does not really need much to turn the mood.

 

We still have very little evidence that this could be the case, but it is definitely recommended to watch carefully and to keep an eye on possible options.

 

The split market was pretty much a reflection of the hide market. Reduced supply and consistent demand, combined with a reasonable sold-forward position, is keeping the market in the pretty steady and solid environment we have seen for a while. Prices are not moving much and everybody seems pretty relaxed. What we have to watch for as far as leather production is concerned is the rising demand from the gelatine industry for lime splits. Prices for this raw material are rising constantly, demand from the food industry for the products is constantly increasing and the leather industry has to consider that in the foreseeable future fewer and fewer splits will be available for leather production. It is going to be interesting to see if traditional producers of full substance wet blue change their minds and move in the future. It might be worthwhile to investigate where the breakeven price for a possible change could be. This could become quite important for those where split, lime or wet blue is an important basis of production.

 

Skin market struggles

The skin market remains in rough waters. While some skins are still enjoying reasonable demand and price levels are inflated, standard products for the garment nappa industry can hardly find a home at any price. One source we spoke to summed it up and called European wool sheepskins as ‘not being sellable’ at all. So, the optimism we had some weeks ago has faded again and it remains a mystery as to why raw material in general is moving higher, but some articles still aren’t selling despite the fact that they are at historically cheap levels.

 

For the coming weeks we feel that the market will now really slow down. There are many indications that a cycle could come to an end. More voices are being heard in the tanning industry saying that they are not able to handle the present conditions in their calculations. Most are just trying to reach the end of the season, or the summer holidays where Europe is concerned. This now leaves a few problems for tanners. How should they prepare the budgets for next season? How should they manage and prepare the R&D goals? Should they cover some of the third quarter raw material needs now or speculate on the expected market decline? How should they prepare in terms of currency positions? There are other problems too.

 

In the meantime a clear direction is still hindered by the fact that we still have isolated market sectors that contradict this entirely. While the market for upholstery hides is already showing some ‘fatigue’, we still have lightweight material or continental European bull hides where, for the moment, supply is not meeting demand. So, whatever market segment is affecting or driving the individual there are plenty of arguments either way and this might be the answer for the short-term. Prices for different market sectors are drifting further apart and this could mean a wider spread than ever before and even conflicting price trends going into the summer.