The global financial market took a long break over the Christmas period, and not only in the western world, so very little of consequence happened. It was only at the end of the first week of January that a little more activity was seen after some interesting data was released.

Most financial experts had anticipated a rapid slowdown in the US economy in 2007 and were scared about falling property prices and the impact on consumer spending. Interest rates were expected to fall again, which would weigh on the value of the $. However, the initial financial data released last week showed that the labour market was actually more robust and that hourly pay rates were still rising, which was not only good news in terms of consumer spending, but also helped to diminish expectations of a further decline in US interest rates.

Consequently, the $ ended its descent towards the end of the year and did not mirror the developments of 2004 where the value of the greenback decreased almost hourly, stopping only at the last trading day. The € continues to gain the most value and has found a new trading range between 1.30-1.33 for the time being. Although the general macroeconomic fundamentals are still not in favour of the $, the descent could still be interrupted and there may be a fair chance for EU exporters to cover their currency exposures at better levels in the first quarter than they would have predicted in their budgets at the end of 2006.

Another piece of good news was the sharp fall in oil prices as a result of the recent warm weather in the northern hemisphere and high stocks of heating oil. Prices per barrel fell as low as $55 and, if the situation in the Middle East remains stable and the weather forecasts (still warm) are correct for once, there might be some additional opportunities for savings on energy and heating costs.

In general, the positive global outlook for 2007 was confirmed with the emerging markets remaining on track, the US looking for a soft landing and Europe also making further progress, with Germany in particular producing consistently better data and prospects for the New Year after a long phase of lagging behind.

Stock markets have also started the year in a steady to positive way and most analysts are expecting another positive year for the stock markets, which would add to further growth in prosperity levels.

So, the general economic outlook for 2007 is like an almost cloudless sky, which is certainly a good start, but it is also important that the risks are not overlooked. Raw materials, and particularly oil, have become a power tool in international politics. China’s international influence is growing as fast as its economy (particularly in poorer regions such as some parts of Africa). Imbalances within the US economy have still not been resolved and tensions in the Middle East can produce further trouble on a daily basis.

Market intelligence

The start of the leather pipeline in 2007 was as quiet as almost everyone was expecting it to be. During the first week of January, most of Europe was still almost completely in holiday mood. According to tradition, many of the big production centres continued to use the first week of the year as a holiday in terms of production and administration work.

We are expecting a similar situation in the southern hemisphere, where people are now taking their annual holiday break. Asia is increasingly adjusting to the global rhythm and, having spoken to a number of people, it appears that activity there has been running in a very low gear over the past fortnight.

Consequently, we have seen very little market activity and market conditions have hardly changed. Not only has the marketing of hides and leather been slower, but the kill has also slowed. Only the Muslim sacrifice festival at the end of the year has increased the global supply, mainly of lamb and sheepskins.

The break granted us more time to monitor, investigate and analyse the situation in order to verify our expectations for the first half of 2007. We conducted a small poll around the globe asking for a general statement concerning 2006 results, the present order, price and cost situation and expectations for 2007. The feedback we received was, of course, limited because of the prolonged holiday season, but a sufficient number was received from both traders and manufacturers throughout the pipeline to allow us to draw some fundamental conclusions.

Poll reveals varying opinions within the leather pipeline

Concentrating on the fundamental results we noticed the following:

• The 2006 results were, on the whole, satisfactory for the tanning industry. We have to admit that this was somewhat surprising as we were expecting more negative reports from the upholstery tanners at least. It was obvious that side leather tanners had had a good year.

• The most significant contribution to the results came from the first six months of 2006, while for many the second half was increasingly difficult with shrinking results. This was unsurprising seeing as the full effect of rising raw material and energy costs hit producers later in the year.

• Most Chinese side leather tanners are still very optimistic about 2007 and this is mainly driven by high expectations for the domestic market. Chinese tanners expect strong growth in domestic sales which is helping their calculations as they are also expecting a further rise in the value of the RNB. This would mean that imports in $ would become cheaper, while they expect domestic retail prices to at least remain steady. This positive trend is expected to offset increasing competition in the export markets.

• Brand names and retailers related to leather consumer goods benefited from the very good performance of the global retail market in 2006 and the vast majority not only reported excellent results, but many even achieved record-breaking results. Although we know that budgets are mainly a reflection of the recent past and consequently not a good trendsetter for the final results, they do have a strong influence on corporate decisions in the short-term. Most budgets for 2007 predict further growth in sales on top of the 2006 levels.

• Most budgets are based on moderately rising manufacturing and product costs and the vast majority are projecting similar profits and margins for 2007. Almost everyone is expecting sales prices to be steady to marginally increased.

• Upholstery tanners are the most cautious about 2007. They had only the chance to buy more economical raw material in 2006 to cope with the margin squeezes. They are anticipating that their fundamentals are not going to improve and we can understand their concerns that they could lose out if it finally comes to a ‘fight’ for raw materials. Some are even considering a shift to side leather tanning in 2007.

• Automotive tanners had bit of a mixed history as well as mixed opinions about the future. This is obviously directly linked to their range of customers and the models they are supplying. While global players are trying to readjust their portfolios and production locations, local players are massively dependent on the model range. There are quite a lot of niche players supplying exclusive models that are hoping the global economy will continue to favour their customer base. A few suppliers have been hit hard as they have been facing strong tailwinds against their profits as a result of currency issues, high raw material costs and a poor customer car model range, which will cause headaches and extra work for management in 2007.

• Like the upholstery tanners, tanners supplying the garment industry were also divided. Those supplying to the luxury markets had only one complaint: the high raw material prices. Those still waiting for an improvement in the standard nappa market were again disappointed in 2006 and expressed little confidence for 2007. They cannot even complain about high raw material levels as their supply is still available in excessive quantity and at historically low prices. The only positive comment received was the hope for certain new articles and the attempt to shift production to shoe and bag leathers. Despite this, it is clear that the situation has really deteriorated as in Europe quite a number of lower quality sheepskins from the festival slaughter have not even been collected, or only against a service fee. The cost of collection and processing is still exceeding sale prices. There have been a number of reports of sheepskin sales from traders who are running out of warehouse space at levels of $1 per piece, ex-works, which would not cover the cost. Better revenues obtained for lambs are still unable to compensate.
  
  
• Not much feedback was obtained from splits tanners. We were really curious to find out whether there is any sign of a recovery of splits in leather production. So far we have been unable to trace any. Split leather has its regular market but is not benefiting at all from the high cost of grain up until now. Since we have seen hardly any suede or increased volumes of nubuck, and fashion remains nappa-driven, producers’ expectations were low for 2007.

Potential problems from the demand side

So where does this brief review leave us for the coming months? Those who were expecting some relief from the raw material markets appear to have been disappointed. The balance between supply (slaughter) and the demand for leather is still stronger on the demand side and the question of whether this could still eventually end in a raw material shortage remains open. Obviously, there cannot be a shortage unless disease or other incidents reduce the slaughter. Otherwise, supply will just reflect the global slaughter which is not expecting any major changes. It is the demand side which could cause trouble.

If things happen as the poll has suggested, it is hard to get a realistic feel of how things will finish. For the short term it seems that key players have sold or covered production for the next eight to twelve weeks. The ‘open-to-buy’ still exists among the ‘B league’ customers, who are acting in a less programmed manner and are either buying hand to mouth or against incoming leather orders. At the end of the day, the situation is fairly straightforward: those who do not have raw material will not be able to produce leather, and those who do not have the appropriate raw material will be unable to produce the quality customers expect.

So, the potential gap can only be closed either by closures/production cuts, or by using the raw materials that still exist, or if the things we are expecting simply do not happen. However, one thing continues to be true: higher raw material prices are not creating more available raw hides.

Increased demand for dairy cows

There is also something rather interesting regarding bovine hides. Several of our sources in China have reported that, due to the strong performance of bag leather, tanners are buying an increasing number of dairy cows which had been produced almost exclusively for upholstery tanning until the middle of the year. With the strong outlook for this sector, more of the same can also be expected in the future.

So those who have covered their raw material base for the first quarter should be relaxed and taking it easy. We cannot expect a significant market change in the next three months.

With demand expected to be steady for the coming weeks, production is running at steady and high levels. So any change in the slaughter will have a more significant influence on the actual situation. It seems that more hides would be easily absorbed by the market while less material could threaten supply chains.

It should be understood that our concerns about certain parts of the trade still exist. A number of tanning businesses are suffering margin and cash-flow problems and we have already seen the two tanneries in China running into trouble recently. Rumours about a number of others around the globe are still being repeated and the strong performance of the market in general will need to compensate. Commodity prices in general have fallen quite a bit in the first week of 2007. The large productions in Asia will reduce production due to the holidays in February and margin calculations are looking much worse than a year ago. All these factors are on the risk side for the market, but it seems they are not strong enough yet to influence the market in the short-term.

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