Macroeconomics

 

The financial world is getting into the holiday spirit in the northern hemisphere and the World Cup is still having an impact, particularly in the countries that are still in the tournament.

 

So, nothing of real importance has happened. Interest rates increased by another quarter of a per cent but the financial community had been expecting this anyway. As a consequence, the US dollar lost most of the gains it had made in recent weeks which raised international exporters’ hopes that the value of the US currency could bolster their business overseas.

In Europe, it seems that Germany’s success and the good mood related to the World Cup is spilling over into both the business world and the private community. Polls about business confidence and consumer confidence have reported the highest levels since the reunification of Germany. This comes as a little bit of a surprise because the government is using the good mood and the World Cup to raise taxes and social welfare contributions. Furthermore the VAT increase that was implemented in January is still being digested by the economy. Nevertheless, for the time being it is boosting confidence in the future of the European economy and is adding to the positive sentiment regarding the euro. The US current account deficit narrowed in the first quarter of 2006, but still remains at impressive numbers. At the same time, China is reporting record levels of foreign currency reserves and it seems that they will pass the $1,000 billion mark before the end of the summer.

 

Fear of inflation

The fear of inflation is sending the price of bonds down and interest rates up. This would normally weigh heavily on stock markets but, for the moment, they have been able to recover from the correction as seen in the past few weeks and most major stock markets have seen reasonable gains.

The real estate markets in the United States and Britain showed positive results in general. While Britain reported another increase of around 5% for real estate values for the last year, new house sales in America were up by 4.6% for the month. Consumer confidence in the US rose again slightly in June and this has lessened fears that the American economy might slow down in the second half of 2006 due to the increase in interest rates, as the consumer will not completely withdraw from the shops. This boosts hopes that the economy could enjoy a soft landing.

 

Due to the positive outlook for the European economy, and rising commodity, in particular energy, prices and higher interest rates in the United States, the market has to now expect interest rates in Europe to rise.  Although the economy in this part of the world may be strong enough to digest this at present, the effect it will have six months down the line remains to be seen.

 

Market intelligence

As much as people may be excited about the football at present, the leather pipeline has not seen much enthusiasm. The assumption we made that we were going to have a reasonably quiet summer and what we termed a ‘rollout’ situation in the market still seems to be pretty much correct.

However, trading activity remains better than one might expect for this time of the year. Buyers are not holding back from the market completely and, at the same time, sellers are not hedging their bets on better times to come. So, whenever realistic price levels can be agreed between the interested parties, the sale is done and product is still moving. Interest rates and currency movements are determining the price levels much more at present than raw material prices. This might be less obvious for those who are located in US dollar-related countries, but for everyone else it is pretty noticeable.

In many countries, it has become pretty common for buyers to buy on extended terms. While a letter of credit with a finance period of 90 or more days did not affect prices too much a year ago, financing terms today are significantly more expensive and, for many exporters, the situation is not only the problem of rising interest rates but significantly higher forward rates on currency too. For many buyers, particularly those in Asia, this is pretty difficult to understand, especially when they are asked to pay premiums of up to 5% on the cash price that  they have seen in most of the reports or in their regular lists.

 

If finances are not subsidised by governments, this makes it more and more difficult to agree on a price level. The general levels for raw material prices are already too high for most of the tanning industry and if the seller then wants to or needs to add additional financing costs on top, it becomes even more difficult to reach an agreement on price. Since there are few businesses based on totally solid finances in the world, and many are still dependant on bank loans or suppliers, this side of the business is becoming more and more important again.

 

Economics still dominates

This brings us back to the point we have made in previous issues of the market intelligence that finance could become much more of a determining factor in the evaluation of the market situation rather than the simple supply and demand situation of raw or semi-finished materials.

We can’t state often enough that tanning businesses’ in particular, but also leather manufacturers’ needs for cash flow are increasing rapidly, and this is not easy to come by. At the risk of repeating ourselves, it is not only raw materials that are going up in price but also energy and chemical costs, which are challenging financial departments at the moment. Apart from the general problem of price and calculations, this will be one of the main reasons why tanners will increasingly work on a hand-to-mouth basis and stick a policy of holding a low inventory. For the time being, with the inventories of raw material from most parts of the world being pretty low, this is keeping the market in the almost perfect balance we have seen for quite a while now.

 

Some activity continues

Despite this, a little bit of variation can be seen in the market compared with some weeks ago. The market continues to highlight a difference between the varied sectors., The outlook for shoes and leathergoods remains extremely good and there is hardly anyone to be found who is not positive about the the amount of business expected in the second half of 2006. The upholstery industry is certainly much more cautious about the future. This doesn't come as any real surprise as rising interest rates continue to place a massive burden on the so-called big ticket items. We would assume that this is going to hit furniture much more than cars, because the car industry is still benefiting from massive growth in the emerging markets at present. However, one must be careful as eventually the high cost of petrol will also hit the expensive car sector too.

 

Confidence in cows suffers

The general situation is already slowly being reflected in the raw material markets. The classical upholstery item, the dairy cow, is suffering from less confidence and from the holiday situation in southern Europe and is the first hide category that has really made some price concessions, declining in value. Most other hide prices remain under so-called weak/steady conditions and are not yet particularly willing to move.

It is worth mentioning that in this period, which could be called the low season, individual situations determine the movements. In Europe, the market is still influenced by a shortage of quality fresh male hides which is keeping the market under tight control and, in some cases, even incrementally increasing. The opposite applies for cows as explained above.

In our view, the most important indication for the next move in the market is the rumour that more economical origins in the southern hemisphere are starting to pile up inventories again. It would not actually come as a surprise because many price levels were quickly raised into what we would call dangerous territory again. Since these parts of the world are also in their winter periods and the kill is basically at higher levels, it could well be that more raw material is presently being produced here than the market is able to absorb. If this is true, a moderate price correction should be expected and we would certainly believe that, at least for hides more oriented towards the upholstery business, a moderate decline could be likely in the weeks to come.

What can we now summarise from these individual summer impressions? Well, most of the global leather production is still being absorbed for shoes and the outlook remains positive. Times of rising inflation are good for small price ticket items and not so good for higher priced goods such as furniture. The inventories along the supply chain are not excessive so we should be well protected against nasty surprises in most of the grades and types in the near future.

 

Pressure on margins

Also true is the fact that tanners are feeling a great deal of pressure on their margins and attempts to increase leather prices are not as successful as they should be. At the same time, leather manufacturers are realising the need for price increases and are not going to be surprised by supply problems or price hikes. The normal reaction – and there is no reason why it should be different this time – is to use either cheaper and/or less leather. This should compensate for a great deal of the positive outlook for the shoe and leathergoods business in general. Hides which are used for the upholstery business in particular will find it more difficult to protect themselves against the trend and they might suffer a bit as the leverage effect on finished product prices moves higher.

This gives us the impression that the period of moderate price corrections may last into the autumn period but will not be too significant. The pressure on prices will certainly be heavier on economical hides which, in some cases, have reached levels that are historically out of the normal trading range. Dairy cows also seem to be at the high end of what they can achieve and, since they have already started to adjust in price, it seems that their correction might be more pronounced than other standard materials. However, even here one cannot expect sharp drops because there is still not enough product accumulated to trigger any massive need for sellers to move it and convince them to reduce prices significantly.

Consequently, one would be well-advised to keep a watchful eye on market developments and not to bet and gamble over whether the raw material market will resolve the margin problems. It may not be a bad idea to keep a reasonable percentage of the required raw material needs for the coming months covered. There is no need to buy in a rush, but protecting against potential changes on the supply side should definitely keep risks to a minimum. Many will remember exactly the same situation a year ago when many people were convinced that the raw material market would decline and stayed out of the market for too long and the consequences of this are known by everyone. Without a clear signal that the global economy is slowing down and retail sales are falling, watching the supply side is definitely important. Everybody should also remember that the production cycle is going to be more active from October.

In the long run, we will all have to watch the development of the general global economy and later this year, and in 2007, the final influences of the sharp rise in energy costs in 2005 and 2006 will be seen, as well as the effect of increasing interest rates.

 

Split and skin markets remain unchanged

There is nothing really new in the split and skin market. Most splits are still in insufficient supply and prices remain entirely steady. There is some increasing activity in the demand for good quality double face skins, from Turkey in particular. For the general medium- and low-end material, particularly for nappa production use, there is still no light to be seen at the end of the tunnel. It is really going to be interesting to see if the cheap prices will attract either garment producers or shoe manufacturers to consider more of this kind of material in their collections and productions.

For the coming weeks we do not expect any particular change. Global activity is going to be determined by the holiday season in Europe and the United States. It is pretty unlikely that we will see any major change in market activity until mid-August. Asian producers will have to act soon for the August/September period because of their longer lead times, but only if we see hides accumulating quickly over the next weeks will we be able to consider the possibility of any major market movement. Otherwise, sellers will only take what they are comfortable with and buyers will have to decide if they should secure product or hope for better (cheaper) times to come. Nobody should forget, however, that less demand also means deteriorating business in the leather industry.