Macroeconomics - 02.03.07

 

Although the financial markets have not provided much entertainment for quite some time, they have delivered a fair amount of drama in the past two weeks and any investor looking for thrills certainly experienced some excitement.

 

Triggered by concerns over possible governmental decisions that could be made in the upcoming parliamentary session in China, which could hamper the country’s economic growth, the Shanghai stock market took a sharp 9% nosedive at the beginning of last week. This, in turn, sent all of the other global markets into massive corrections and has now left investors pretty concerned about their strategies.

 

Despite some recovery in the market later in the week, it was another example of how storms can build even when there is not, as yet, a cloud in the sky.

 

Most financial investors are now saying last week was sound requiring correction, but the warning signs should not be ignored. Although a number of macroeconomic indicators, such as the global growth rate, the recovery of the European labour market and all the indications of a soft landing in the USA, are still positive, there are also a number of problems which exist beyond this fundamental data.

 

Some elder statesmen of business such as Warren Buffet and Alan Greenspan are mentioning their concerns about the potential influence of hedge funds and private equity companies on the markets quite openly. Reasonably productive investments can no longer be found for the excessive global liquidity and this has led to a liquidity bubble which is now concentrated in equity deals of ever-increasing size. And whilst this is no longer concentrated in one market, as it was in the last bubble of the ‘New Economy’, but spread all over, this doesn’t make it any better and the market protagonists now have to produce more reasons and new arguments on a daily basis to justify their existence and must constantly play down the risks.

 

 

It is pretty obvious that behind the scenes more players are discussing the risks and the nervous reaction seen in the markets is adding to the uncertainty. Maybe it is possible that the markets can be stabilised again and the performance can be extended further, but the risks are rising and the snowball effect will run its course eventually.

 

Apart from the stock markets the currency markets have also witnessed some volatility. This time it was less to do with the relationship between the euro and the US$, but more to do with unwinding carry-trades based on the yen which has sent the Japanese currency sharply higher against the US$. After touching 122 yen for the US$ it settled as high as almost 116.

 

The oil markets also delivered more uncomfortable news and the price for the barrel rose to more than US$62 based on the speculation that an escalation in the confrontation between the USA and Iran can be expected.

 

We also reassert our opinion that there is the potential for much higher inflation than many of the analysts and experts are willing to admit.

 

 

Market intelligence

 

The last two weeks were largely dominated by the holiday season in the first week and the return from the holidays in the second.

The moderate corrections we had considered as a possibility occurred in some segments of the market, particularly in Europe, whilst at the same time prices in Brazil were sent flying and jumped even higher—at least as far as asking levels were concerned.

 

This reflected the trends and impressions seen in the local markets. While Brazil, for example, is still benefiting from the sharp shift toward more economic hides on a US$ price basis, European market players were influenced more by the rising problems reported in Northern Italy. Whoever you speak to in the trade there are very few who do not have mixed feelings about the situation in this market. Furthermore, the number of important names which are being thrown around in connection with rumours of containers that are stuck in ports, the re-sale of inventories, and the restructuring plans of tannery groups, etc., are not doing anything to lessen the concerns which have been troubling a number of pundits for a while.

 

Traditional European fresh hide delivery programmes for dairy cows have been reduced or worse still not even renewed and some are now saying that certain producers will have to rush to place the extra volumes salted into the Orient. However, the market pessimists who can smell a market collapse in this statement should take heed. As far as Europe is concerned the kill hasn’t been that high so far in 2007 and the outlook doesn’t look much better. With the comfortable sold-forward position and the basic need for hides, we are still far from a “take-the-best-bid- you-can-before-the-market-falls-further” situation. There is still insufficient hide inventory building to really scare the raw material suppliers, no matter whether they are butchers or traders.

 

Signs of segmentation

Remaining in Europe, there might, however, be some truth in all of the rumours and the more we talk to our sources and advisors the more we get the feeling that the market situation is starting to reflect what we call ‘segmentation’— where different areas of the leather markets perform differently—a phenomenon we have already seen a number of times in the past and which has been starting to show in the results of the last few months.

 

As a result, we believe that we might have to move away from general statements about inventories and may need to start being a little more precise. This means that there are already accumulated jams in the pipeline of specific hide types for specific reasons or that is merely a case of it being the wrong hide in the wrong place.

 

Where hides have definitely started to move more slowly is in the extra heavy bull hides segment which is dominated by either the automotive tanners or absorbed by the vegetable tanners in Europe. The prices for these hides were sent far too high again in mid-2006, due to either a fundamental need to fill production or the strong performance enjoyed by vegetable leathers in the last year and this led to inflated price levels.

 

In the meantime, it appears that the previously announced plans by many car tanners to move away from this particular raw material seem to be taking effect. At the same time, the vegetable tanners have also recalculated their deals and have realised that they cannot afford the current price levels. Consequently, prices are adjusting and a number of available hides can be found along the pipeline. There are not too many fresh hides available as the basic demand for production is still cleaning up the reduced slaughter numbers, but hides which had been put away as salted or even wet blue are now struggling to attract buyers. And so the market logic will work again as one can assume that price for this type of material will deflate until it finds a level where it either qualifies its traditional customer base again or finds new friends amongst the shoe and furniture upholstery tanners.

 

The optimists—and these are clearly those who have accumulated stocks—are now claiming that the rapidly falling production of heavy hides in the second quarter will swing the market balance back into their favour quickly and that the insufficient supply will allow them to filter their stocks back into the market—at their price levels of course. However, this doesn’t seem to be a reasonable option to us unless the general price level does not rise again sharply.

 

The second segment where hides can be found are with the tanners that are short of cash. Nowadays it is not uncommon that larger blocks of hides are quietly resold and fortunately today’s price levels prevent sellers from any large losses. Standard hide types and grades are also quickly finding homes and are easing a fair amount of the possible shortages in the market. More problematic are the stocks of unused and unneeded selections that tanners are trying to move to raise cash.

 

Some time ago we dealt with the problem that the demand for upholstery leather in Europe leaves the average selections out. Although the top, exclusive market is still performing well and the lower price products are also doing well and finding adequate demand, the critical market is the medium/medium-high end market of ‘European classics’ where either price levels or volumes are not sufficient and are creating losses in calculations or in inventories with questionable valuations. There would have to be a new hype in the market to solve this problem and get this situation straightened out.

 

So, to summarise this, either tanners not getting the raw material at the right price or tanneries are not getting rid of the hides at the same. This is not a problem as long as the market goes up as this will mean using up old stock and feeling comfortable with the inventory you have, but if the market doesn’t move or even goes down…well… the situation is totally different.

 

 

Final decisions expected

All in all we think we are now getting closer to the point where final decisions will be made in this market. Leather prices have to go up to prevent serious problems in the pipeline later in the year. And this does not only apply for Europe.

 

A rise in leather prices is not as completely impossible as many in the trade claim. Results from shoe and accessory manufacturers and retailers have been, in the majority, very positive and they can afford to let their suppliers participate. It all depends on what their valuation of risk is: losing business through suppliers that do not perform due to insufficient profitability, possibly losing profits due to reduced margins which can not be compensated for by higher sales or losing sales by raising prices. Most likely it will be answered by a mix of these factors and normally results in the reduced utilisation of leather. A move towards cheaper leather and raw materials doesn’t appear to be an option anymore as we have learnt in the past few months that hardly any hide type is really much more economical than any other anymore. Whatever happens, the coming months will again be the time for the big players to negotiate their prices, in Asia in particular, and by late spring we should know what the wise decisions were.

 

A first indication of the future trend might be given at the GDS fair in Düsseldorf, Germany, in the coming week where discussions about prices, designs and the future fashion trends should offer us a certain insight into the current decision processes.

 

The split market remains flat which is no surprise as there would have to be a new trigger from the fashion world to bring the split in the shoe business really back into play. Normally it should have already happened, but fashion is remaining stubborn and not allowing split leather to become a performer again. ‘Quality leather’ lovers aren’t too unhappy about this as although splits have their part to play, in fashion and beauty they should, for many, only play a supplemental role. However, in the past economic factors were the deciding factor and why has this not happened this time looking at the price gap between grain and split these days?

 

The skin market is showing steady interest now. Nappa leather now finally appears to be making inroads into the market again. A great deal of glossy and shiny surfaces have been seen at recent fashion shows which of course also support vinyl and plastic, but leaves also plenty of room for leather too. Apart from nappa leather, Turkish tanners are again cruising around Europe to secure new season lambs and they also appear to be quite positive for the next production season. Rising wool prices will also support the skins market, so the outlook for skins remains at least steady if not fundamentally positive without unforeseen shocks.

 

For the coming weeks it is hard to believe that the market will be able to free itself from the current narrow price band. Neither buyers nor sellers have sufficient arguments to move the market into their desired direction. We still believe that the market is l in a minor correctional mode which some grades have already been through or started and others still have to do. It wouldn’t be surprising to see some settlement in other markets too. At the end of the day it all depends on whether global suppliers will risk waiting until their trips to Asia around the Hong Kong leather fair at the end of this month or if they will decide it more appropriate to make minor concessions and follow the arguments of their buyers for the moment in order to maintain their extended sales positions.

We think that quietly and behind the scenes many professional agreements have already been made. We don’t have too much faith in the official price lists and quotes circulating and believe that we have a two-fold market again at present— one for key volumes and programmes and the other for sporadic sales. We tend to believe that for the real standard businesses adequate agreements have already or will be made in private, while the rest will remain around present levels up to the end of the month when possibly new trends will be set.

 

The immediate need for product has, in our opinion, already been predominantly covered in South America which explains the performance and prices in this market so far in 2007, while the other key supply markets are on hold for the time being. We would not be surprised if this ends in a final poker game just before, during, or just after APLF which will be exciting to watch as seldom do the players at the table hold equally strong cards. In the meantime, we can only renew our opinion that an intense monitoring of the financial markets should be a must in 2007.