As far as fundamental economic data is concerned, we are theoretically living in a perfect world. Stock markets are performing well, oil prices have settled at around, or slightly below, the $60 mark per barrel, currency volatility remains low, and the world believes inflation is under control and that the US economy is facing a soft landing.

In Europe, the economy is seeing further and moderate improvement led by Germany, where the business climate index has risen to 105.3 from 104.9 and better tax income is narrowing the budget deficit. The emerging markets are also showing no signs of fatigue and continue to grow at rates of between 5-15%. The vast majority of leather related retailers and brands are still reporting good results and positive outlooks.

So, from a superficial perspective, the outlook for the immediate future appears to show that things are in perfect order for the coming months.

However, we are still concerned with generally high commodity prices, uncertainty regarding the US economy and the potential effect of the US elections on global performance. Nevertheless, the economic situation is positive at least for the short-term.

Market intelligence

It is becoming more and more difficult to squeeze out further exciting news or insights from the leather pipeline and the more people we speak to the more people feel that they have turned over every stone in the hope of finding a new or exciting direction.

To summarise, we are still dealing with a fundamentally strong global economy. The transfer of wealth from the west to the east continues and also fractionally from the north to the south. In any case, those in the east who had little or nothing are starting to acquire a little or something, and in the west many who had little are beginning to end up with nothing. Meanwhile, all those who already had a lot now appear to be gaining everything. To put it more plainly, the wealthy are becoming increasingly richer across the world: in the western economies relative poverty is becoming more of an issue in certain parts and serious poverty in the east is gradually beginning to decline.

Why are we discussing all of this which seems to have nothing to do with the leather pipeline? Many publications have recently been debating the importance of the economic situation in the USA, Europe or Japan for the global economy. Most journalists or analysts came to the conclusion that in the near future, or maybe even today, a slowdown in the ‘old economies’ would no longer have too serious an impact on the world, as growth in the emerging markets would easily offset the decline.

In many instances, the leather industry has already been a history trendsetter or a trend indicator. So why not in this particular case also? For quite some time, only the United States and maybe the UK have been performing well as far as consumer sales are concerned. Japan and the rest of Europe have not shown any significant performance over the past few years. It would probably be more accurate to call them the ‘lame ducks’ as far as private consumption was concerned. This is not great news and almost everyone agrees that the strong performance of the leather pipeline over the past two years is related to strong demand from the emerging markets in Asia, the Middle East and the former Eastern bloc. When we take this into account, along with the point we mentioned about the rich are getting richer, one could also come to the conclusion that this may well limit the strong performance in the leather pipeline. And this is the key topic of conversation these days.

Growth only possible in mass markets

We have been dealing with the fact that the luxury market has no limit as far as portable spending power is concerned, but due to the limitation of top quality raw material and the leading luxury brands maintaining exclusivity by their scarcity, further rapid growth in the top end of the market is not really appreciated. Even if this was not true, the extent of growth would always be limited simply by the size of the market.

Consequently, major growth can only be achieved in the mass markets. If our assumption that the growth in the mass markets is mainly coming from the emerging markets, which still have limited income, is correct, there must also be a cap on leather prices, simply because the income of potential purchasers does not permit substantially higher prices for such products. If the analysis of many economists is accurate, this does not only apply to the emerging markets. The old economies are losing increasing numbers of middle-class consumers and as the discount mentality, combined with limited disposable income, are dominating purchasing decisions, the situation in the old economies is similar to that of the emerging economies. Although the reasons are completely different, the consequences are the same. Finished product prices are limited and, since retailers are not willing to make concessions on their margins, suppliers and manufacturers must find cheaper alternatives.

We realise that this is nothing particularly new, but combining the driving forces of new economies with the situation in the old economies it becomes pretty obvious that leather prices will eventually be run against the wall. Perhaps this was indicated two weeks ago in Bologna when many tanners mentioned that their buyers were not complaining at the moment about the volume of business as such but at the same time have been asking for cheaper alternatives, certainly denying the possibility of any rises in finished leather prices.

Price spread narrows

This situation has also been confirmed by the many reports we are receiving from our regular sources, mentioning that their buyers are also desperately asking for cheaper alternatives as far as raw material is concerned.

The problem these days is that there is no cheaper alternative under the present market conditions. The so-called cheap, lower quality raw materials have been the strongest performers and, in relation to the quality they are offering, they are certainly not economical anymore. However, we get the impression that quality is not the issue, or at least not the whole issue, anymore. Looking at the raw material markets, the price spreads between the different grades and different raw material qualities has become narrower than ever before. We just need to take our American colleagues seriously who recognise that there is hardly any spread anymore between the different grades of the classic big packer steers.

Even looking at a simple comparison between raw material prices of the main supplying regions and their price levels, today’s Brazilian prices versus the average quality of continental European and American hides, the spread has become significantly smaller and the traditional price spreads have been substantially reduced. The simple justification for this is that the classical implication of quality difference is no longer reflected in prices because they are no longer reflected in finished products.

Quality factor declines in importance to consumer

Since the middle price section of finished products in the traditional consumer markets has almost disappeared and, in the large retailers’ attempts to optimise retail margins, certain consumer price ranges have almost disappeared from the shelves. By trying to optimise retail margins, large brand names and retailers have squeezed manufacturing prices so far down that, in the downstream calculations, the ex-factory prices for different products have become closer than ever before. This does not allow components to vary much in price either. With further requests to reduce prices, the only solution is to make substantial quality concessions and, in a world where the consumer has not only less choice but also less knowledge of design and fashion, the driving force is not the quality of components anymore.

While the above may explain the existing levels, it could also explain why the limit on finished leather prices could eventually also limit raw material price levels. Retailers are not willing to restore a wider range of prices in relation to quality so they will have to look for substitutions to stay in line with their target purchasing prices.

Global demand remains positive

We all know that the leather business is very cyclical. Fundamental changes can only happen within the rhythm of purchases and orders from the retailers or the fashion seasons. And even then it normally takes more than just one season.  Sometimes it takes two, which means roughly a year. We possibly saw the beginning of this two weeks ago in Bologna where quite a number of people were talking about the request for substitutions in the form of cheaper raw materials and leathers. Looking at today’s prices for rather questionable raw materials, it does not require too much courage to say that there are strict limits with regards to what can be converted, not only from the price point of view but also from the availability of cheaper raw materials.

However, for the time being the leather pipeline is still not overly concerned by these issues. Leather and consequently raw material demand remains brisk around the globe. The present level of orders and production are still not allowing any accumulation of inventory along the pipeline. The few exceptions we mentioned in our previous report are still not building enough momentum to have a real effect on the market. Raw material suppliers remain in a comfortable sold position and, apart from some minor variations and local hiccups, no major change in trends can be determined.

Raw material shortage still a problem

The splits market remains a bit of a mystery. The performance should be much better, at least as far as leather is concerned, because of the pretty high levels one has to pay for hides these days. Gelatine and collagen selections are still performing well in Europe at least as well as some niche products in the leather field. However, the mainstream splits for standard and traditional cheaper leather items are still not really seeing the positive performance one would expect. It may be just a matter of time, because the industry can hardly ignore the splits when everybody is desperately asking for more attractive leather prices.

The skin market is not showing any fundamental change, which has been the case for quite a long time. Fine wool-on-skins and top quality nappa materials are still doing exceptionally well. With the drought in Australia, supply is becoming a more prominent issue for the skins specifically delivered from that part of the world. Despite all the supply and price problems there are still plenty of cheap skins available around the globe. China, the biggest player in the market, is enjoying abundant supply from the local production of average and lower quality skins for nappa production. So China’s performance in the international markets and the hope of more business concluded there has not been fulfilled so far. However, the real hot season is still to come in the first quarter of 2007 and if there are indications that more lamb and sheep could be used for bag and shoe leathers we might see some change in the coming months. Hopefully this is not just wishful thinking.

For almost a year now it has been almost useless to make any kind of forecast or predictions as far as the development in the leather pipeline for the coming weeks is concerned. The raw material pipeline remains fairly empty and this means that sellers have no reason to respond with any price concessions. The courage to raise prices is also rather limited as the key players around the globe clearly understand that this would not lead to any additional sales. With a comfortable sold position they have learned their lesson and all they are trying is a fine tuning on the upside. It is more important to keep the forward position at present levels, as those who have been in the business for more than a few years understand that too much ambition - despite being in probably the best fundamental situation a seller could be in - would not add to extra sales, but would incur a number of risks. Consequently, we believe the time for change is yet to come and we repeat our concerns about profitability and cash flow needs, because they will eventually mean something to the pipeline.

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