Macroeconomics

The level of nervousness in the financial markets is rising. Stock markets are continuing their daily rollercoaster ride and financial experts are now discussing the future of local economies and global trends.

 

Rising energy prices, political issues over the situation in the Middle East, inflation, and rises in interest rates are creating a potent cocktail—a situation the financial community always finds more difficult to deal with. In this regard we have to realise that, at present, economic issues play a less important role than individual interests related to speculation or positions in the market.

 

Most of the financial community, such as banks or brokers, have their own interests in the markets to consider and nowadays an increasing number of market trends are more closely related to speculation on hedge funds rather than a reflection of the real imbalances in the market. Consequently, a number of movements in the markets today are more as a result of individual positions and interests. With the size and concentration of the financial power, much more depends on the sentiment of the market players rather than the fundamental data.

 

Assuming that our interpretation of the situation is correct, we must assume that more and more big players are taking different positions on the market, and many of them are no longer betting on a positive economic future. In the good old days this was called a move from strong hands into weak hands.

 

No one should forget that for every sale or purchase you need two parties and one has to be dubious about how much, banks in particular, are still painting a positive future for assets and in particular stock investments. Maybe they are preparing their exit to release them from the long positions they are running in investment funds. Only time will tell, but the state of the financial market is finally also influencing the leather pipeline.

 

Currency markets react

Just how sensitively the market is reacting and how uncertain the situation is can be seen clearly in the currency markets. The US$ took its first break from its descent and now the only question remaining is which national banks are going to raise interest rates and when. The rise of the euro is also reflecting the influx of capital into the region and is increasing inflation and money supply. However, the latest unemployment figures in the USA on Friday triggered another round of selling of the dollar and it slid again. Critical levels are in sight again and against all the experts opinions we still believe that a sharply weaker US$ will create unpredictable tensions in the global economy in the longer run.

 

The rest of the leather-related markets did not deliver too much news. Only the US car market confirmed a further shift to imported—or better said—to non-US brands. Although, this does not necessarily mean they are not manufactured in the USA. Detroit’s big three lost significant market share again, while the Asian brands in particular continued their success stories. This is now mainly related to fuel efficiency. Despite the bad news for manufacturers, the total number of cars manufactured and sold globally has not changed particularly. Sales in the emerging markets are currently growing fast enough to compensate for some of the difficulties that isolated brands are having to deal with in their home markets.

 

To draw a line under the macroeconomic section we would like to remind our readers that we don’t want to play the role of the pessimist, but we feel that the position pointing towards the risks that are lurking on the horizon is being understated at present.

 

Market intelligence

 

As is usual for this time of the year, the general activity in the leather pipeline has not been very impressive over the past few weeks. The market continued to be dominated by gap-filling activities within the pipeline and the normal major trends were delivered. The Guangzhou leather fair in China delivered a positive impression on the whole. Visitors and exhibitors were quite pleased with the attendance levels and although the actual volume of visitors was not considered to be higher than last year, the quality of the fair traffic was considered to be pretty high.

 

It is always very difficult to make generalised statements about the result of a fair, because too many different exhibitors, products, services and interests have to be covered. When we come, however, to our fundamental interest—and by this we mean the activity between raw material, tanning and manufacturing—most reports were positive. Filtering down all of the reactions we received, two dominating sentiments were determined. One was the fact that leather demand, in particular for good quality leathers, was satisfying on the whole and second that leather prices rose by figures of around 10%. As a third impression we might mention that tanners are trying to deal with the problem of profitability by searching for cheaper and lower quality raw material.

 

Another interesting topic of discussion we heard is the rising debate about environmental issues in China. Although nothing has been decided and no official statement has been  made, more and more frequently the industry is debating the option of the whether Chinese officials will hinder tanning operations and promote industrial operations starting from semi-finished products. This is nothing particularly new, but why should China act different than other countries? China is a net importer of raw material and is most likely going to be one for quite a long time to come. To secure the raw material base it would not aid Chinese policy to limit manufacturing by reducing access to raw material. However, this will not exclude that the government from casting a very critical eye over small operations that cause pollution and the government may  take quick and efficient decisions to close these operations down in favour of new investments or to protect environmentally friendly and adequately equipped factories. Since the total tanning capacity in China by far sufficient enough—or better said there is overcapacity—a certain shift and/or reduction would be nothing anyone would be unhappy about. With the exception of those which have to close, of course.

 

Another very important subject which was dealt with in China was the release of more and new information regarding the customs policy of the Chinese government. Chinese tanners that already have their customs books will allowed to proceed as before with the same quantities imported in 2005. If you look at the bottom line, it's not really anything particularly new nor does this really change the market pattern. We honestly think that far too much ‘ballyhoo’ has been made about the subject and the influence it will have on the market.

 

The interesting question is much more how one can explain the significant increase of raw hide imports into China in the first half of 2006, and even more what this means for the second half of the year or for the future in general.

 

China’s imports rise 20-25%

As far as statistics can be used, China has imported about 20-25% more raw material than in the same period in 2005. Is that really worth getting excited over? We don’t think so. If one goes back to the beginning of 2005, the leather industry was not exceptionally positive. Inventories in the pipeline were sufficient and the trend was more to reduce stocks as the global sentiment was that there was abundant supply and reducing risk and capital cost by lowering the stock position was a common decision and company policy. Consequently, raw material purchases were not the focus of interest and were rather under average in both China and in every other region of the world. Quite a reverse of the situation has been seen in 2006 and, with China being the largest user of raw material these days combined with a steady growth in production, one can be impressed, but not surprised by the volume or the increase of raw material purchases in the first half of 2006. In addition to this, we have to remind you that Chinese buyers slowed their purchasing down at the end of 2005 because of the uncertainty over the new customs policy and the hope within the industry that this could drive raw material prices down—which it did not due to the rising global demand—and so the Chinese industry has had to make their purchases in the first quarter of 2006.

 

Much more interesting is the consequences of this for the future. China or no China, the main problem today is the fact that average raw material demand in the last season has exceeded global production of bovine raw material. As a consequence, today global hide production is at insufficient levels if demand remains where it is. In some of the main hide categories, supply isn’t meeting demand and with hardly any speculative traders’ positions buffering raw material, we see that it will be difficult for supply to meet demand for some time.

 

If our assumptions so far are correct, then the conclusion of almost everyone outside the leather pipeline would consequently be rising prices. So far this has also been true but then, to explain to those not familiar with the leather pipeline, we have to deal with other parameters connected with other industries and commodities.

 

• Higher prices for hides do not increase beef production, because the critical price level to influence supply is far away from the present one. There are still miles to go before hide prices could subsidise the beef price by that much so that beef demand would be accelerated.

 

• Leather is still a product where demand can be influenced much more quickly than supply of the required raw material. When buffers have eroded then there is almost no room left to manoeuvre on the supply side.

 

• Consequently the gap between supply and demand will always be closed quickly and this normally happens more quickly through demand rather than supply reactions.

 

• The present market situation is not new, but today more (statistical and market) information is available. The pipeline is much more tightly managed and inventory controls are significantly more important than in the past.

 

The questions now to answer are:

 

a)     Has the leather industry replenished stocks sufficiently so that the demand for raw materials is going to ease moderately into the next season, because the desperate immediate need to continue to purchase is fading and/or

b)     will rising prices for leather depress leather demand for the next season, so that less raw material is needed?

c)      Can the utility and use of leather in finished products be increased that much that the gap can be closed by designing and maximising product use?

d)     Do we have excess production capacity in the market which is going to be shut down due to declining profitability and increasing cash flow needs?

 

Since there is no way for the leather pipeline to get back into balance other than to close the gap, everyone has to evaluate the problem and find their own solution. Historically, the normal response has always been a bit of everything, with one factor dominating. If any of our readers feels they have an interesting standpoint on the subject, we are always looking for further input. It is still a bit too early to get a clearer picture at present as the market reaction can most likely only be expected with the new season when the production cycle starts again after the summer.

 

Not much more can be said for the split market than for the hide market. As already stated in previous issues, the only different parameter seen is non-exclusive demand from the leather industry. In splits we are also dealing with the influences from the gelatine and collagen industries where calculation, i.e. breakeven levels, as well as alternatives are completely diverse.

 

Skins still struggle

Skins are having a bit of a hard time again when it comes to nappa leather use. The top quality level as well as specific niches are still running normally, but the broad-based nappa market is struggling due to insufficient demand from the garment sector. For some time there has been little chance for a change and the only interesting subject for us in this field is the fact that this cheap and available raw material for the tanning industry will eventually be discovered by leather segments other than the standard ones. So far we have not been able to trace anything.

 

For the coming weeks we repeat our opinion that the market is going to settle further. Any impact on prices cannot be expected for the moment, at least not until some of the questions we raised above have been answered. However, in our opinion we are slowly but surely entering a phase where more balance in the market is being achieved and, later in the summer, the market which is presently almost entirely a seller’s market will see a better ‘balance of power’ again. This should also result in a realistic opportunity for more a relaxed situation and allow price elasticity to return. For a fundamental change it will, and should, require some more time, but we would not be surprised if we come to the end of this one-way-street before productions fully resume after the summer break.