This has been another period where not a great deal happened in the financial markets. Once again, there were moderate gains in the stock markets and many are close to, or have already hit, record territory. There is still enough liquidity around to push equity prices higher, although the number of warning voices is growing. The amount of cash circulating is still substantial enough to prevent a crash in the market, but profit earning estimations for the future and the function of large hedge and private equity funds could eventually create some unpleasant surprises.

Oil prices continued to trade in the high fifties due to the very cold weather in the USA, while the warm winter in Europe hasn’t played much of a part because energy efficiency in Europe is much higher than in the USA. January 2007 has been recorded as the warmest January since the first global statistics were recorded.

Economic performance in Europe is improving. GDP in the last quarter of 2006 showed growth of 3.3% and Japan also demonstrated an improved performance with a GDP increase of 1.2% in the same quarter. Meanwhile, the USA has not really been able to please the financial markets due to a widening trade deficit to $61.2 billion in December, as well as the housing market providing very disappointing figures and a fairly flat labour market.

The financial community was eagerly expecting Mr Bernankes’ testimony last week, but was disappointed by the lack of new information. Basically, he described the US economy as being on track, while he also pointed out that the economy is still facing all kinds of risks which need to be watched out for. So, pretty much like all central bankers these days, a statement like the weather forecast for summer in winter. It is rather a believe it or not believe it question, rather than a great indicator for the time ahead.

The currency markets are also a signal that the interest rates in the USA will not continue to climb, or at best that they will only climb slightly, and this combined with the rising trade deficit and the flat housing market has sent the $ sharply lower against the €. It ended the week at a level of 1.3140 and it appears that there is still room for further adjustment.

Having said this, one also needs to watch the Yen which has been pushed lower to record levels over 120. Currency policy from the Japanese government and the central bank, which introduced low interest rates to boost the economy, could eventually become a danger to the currency market when all the carry-trades borrowing cheap Yen and investing into higher yielding currencies and market have to be questioned. If interest rates in Japan are forced to rise again at some point, there could be serious problems when these investments need to liquidated quickly. In the meantime, the Japanese economy is feeling the benefit of being in a position to offer their goods at attractive levels in the global market.

The Chinese central bank has announced that, effective February 25, banks will have to increase their reserves against loans by another 50 bp (0.5%) in an attempt to fight inflation and to control liquidity supply. This will tighten the credits further and the impression is that this step might not be the last one in 2007 to control the fast growth of the Chinese economy. Banks now have to keep 10% of the loans as reserves.

So, following the macroeconomic developments seems to be very important, particularly for local businesses, to protect against hard-hitting surprises.

Market intelligence

In our last report we mentioned the wind of change which we sensed in the global leather pipeline. Collecting all the pieces together, it seems that one needs to keep an eye on the risks more than on the opportunities at the moment. Some of the concerns and feelings of caution could be related to the slowdown in activity caused by the Asian holidays and the short dip in activity from Europe around carnival time.

However, there is an increasing number of developments worth watching out for and it seems that the ‘all is perfect’ world is continually changing into a ‘some is good and some is bad’ situation.

Here are a few examples:

• While it is estimated that the global production of cars in 2007 will rise to 66.5 million, the US industry is shrinking and, in the last week, a restructuring plan to rescue Chrysler has been unveiled. Production is to be cut by 400,000 units and this follows similar action from Ford and GM.

• The winter conditions in the USA have been pretty rough lately, while in the rest of the world temperatures are more spring-like. Consequently, winter shoes and apparel in the States still found buyers while other stock was largely unattractive to consumers.

• While there have been further reports of shutdowns in Europe (such as the closure of a large leather furniture manufacturer in Germany at the end of January), Asian manufacturers are still planning expansions. The latest example is the megamillion dollar investment plan for a leather complex in Kasen, in western China.

• While raw material sales and export statistics are still painting a very positive picture of the market, actual shipments to the tanning industry have not confirmed this. The market dynamic and the amount of raw material shipped have lost a lot of the pace seen in 2006 – at least from the USA and Europe. This leaves us questioning whether this is related to the Asian holiday season—in that tanners were not willing to take normal quantities for shipment in January and arrival in February—or whether it is a symptom of the pipeline seeing some slowdowns.

• While the raw material markets in the medium and higher quality segment are facing strong price resistance, the more economical origins continue to enjoy a positive performance; the trend of downgrading raw material to save on raw material costs has not stopped. This has led to pretty strange price structures and, with the last quotes seen from Brazil ($1.40 per sq. ft. for TR1), there is now little price difference between the top end and the low end prices from Europe. However, this is not actually reflected in the real quality/price ratio. The reason for this is obvious: margin and cash-flow problems are pushing tanners down the quality ladder in an attempt to save money.

This handful of examples may not appear overly impressive to many, but it is enough to demonstrate that the situation is not totally perfect and, depending on the observer’s perspective, many different conclusions and interpretations could be reached.

In our analyses we have concluded that there is no change here from the arguments we have already presented in the past:

a)     The leather pipeline is becoming increasingly segmented and the different segments are developing at different rates (side leather - good, upholstery - meagre)

b)     Profitability and cash-flow are stronger factors today than ever before

c)      The restructuring process within the industry is still in full swing and, apart from the question of who has the deepest pockets, it is also a question of being in the right segment in order to prevent extensive damage

The main changes in the industry and the biggest effects of restructuring in the dynamic process of its evolution have tended to come at almost regular intervals every decade. One could argue over whether the last big move (the second production shift to Asia) was in the last millennium or in the new one, but if we consider the actual situation as being the beginning of a new restructuring phase, the restructuring could take off later in 2007 and last two or three years, and this would fit with the pattern again.

Climate change to impact leather industry

We also need to bear in mind that the raw material supply and beef production are also constantly shifting. Countries such as China are building cattle herds very quickly and one shouldn't be surprised if the reduction of beef production in the Eastern bloc could also gradually come to an end. South America will remain a strong factor in beef production, while the increase in the cost of animal feed could have a negative effect on beef production in North America and Western Europe. Recent discussions about climate change and the massive increase in the production of bio-ethanol could also have a greater impact on the beef industry than many may currently be anticipating.

While we are just getting back to normal day-to-day activities, most would agree that activity has been pretty low, particularly leading up to the New Year break in Asia. The optimists will claim that this is of no importance because when tanners return after this break they will realise that their raw material inventory is seriously lacking and will have to return to the market facing the same problems of price and availability that they have been facing for some time. The pessimists will point out that tanners’ profitability has been shrinking for a long time and that cash positions are far from adequate, which will eventually kill tanners’ appetites and their ability to buy at high levels. This particularly applies to upholstery tanners.

One way or another we will be more knowledgeable in a week or so when operations return to normal and tanners have to prove their buying needs. We remain on the cautious side and surmise that the picture being painted in the markets is more positive than the actual reality.

The other markets were as uneventful as the cattle hide market. Some are saying that splits are performing better, although so far we have been unable to confirm this. In side leather and accessory leather there have been reports that, despite high prices for hides, the trend for better leathers (grains) remains intact and customers are specifically asking for ‘the real thing’. Prices for splits are unchanged and it will be interesting to see whether splits can achieve a strong recovery in upholstery production due to the price problems specified above.

Better demand for low priced lamb and sheepskins

Lamb and sheepskins are revealing a different picture. The higher priced skins are facing more resistance because the margin problems are similar to those for hides. It may be a bit easier since top quality skins predominantly find homes in the luxury market, which is governed far less by price. Lower priced skins, which have been struggling for so long, have found a good deal of demand in the market, particularly in China and the Middle East. It also seems that a high proportion of stock that had been burdening the markets for so long has been cleared.

Despite our concerns about the general state of the leather pipeline, we do not think that the market is due for a sharp reaction yet. The concerns and worries have not yet set in everywhere and the general comfort of full order books is still dominating the scene. Maybe we are being overcautious again and still believing in the fundamental economics too much rather than in the brutal market realities of supply and demand but, since we always try to aim for a wider perspective, we fail to believe that all the problems that are clearly visible can just pass by without having any effect on business and eventually on the markets.

So it might be worth thinking about a moderate correction in the purchasing activity and take a risk by being patient with regard to covering needs for the second quarter of 2007.

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