MARKET INTELLIGENCE – 16.03.07

Macroeconomics

The financial markets have calmed down over the last couple of weeks but the rollercoaster ride does not appear to be over yet. The financial community is trying to play down the risks of further unrest and is largely referring to it as a normal and necessary correction.

Opinions about the American economy are drifting further apart. Optimists foresee the economy regaining strength in the second quarter and their main arguments are that unemployment figures (down to 4.5% from 4.6%) have improved and that inflation is now more controlled. They are also taking into consideration the real estate market at the end of the correction mode and are not expecting the dual deficit (budget and trade) to be a real hindrance to economic development.

The interpretation from the pessimists is quite the opposite. Their main concern is the real estate market and they feel their position is underpinned by the high number of failures in keeping up mortgage payments. They also see the deficits as a problem in the medium term and the measurement of inflation a juggling of numbers rather than a safe guide about consumer prices.

If one considers the currency situation to be an indicator, the pessimists are in the lead at the moment. The $ lost value again and fell to 1.33 against the € at the end of last week. Worries about the economy and the possibility of falling interest rates in the USA are sending the greenback lower. The financial community also took serious note of Chinese plans to set up an investment company to manage their foreign assets and to achieve better returns. This was taken as a sign that the Chinese might increase their attempts to diversify their foreign currency reserves, which would mean selling more $ assets. Whatever happens, this was another hint that the US economy is more dependent on foreign investment than ever and this hasn’t improved despite the narrowing of the current account deficit to $196 billion in the final quarter of 2006.

At the same time, investors (principally from China and Japan) can have no interest in undermining the value of their key investment currency and so things may still be under reasonable control. It will be interesting to see where the $ will head as we are only a little short of the $1.36, the last low since the greenback started the slide. A steep fall—and this can’t be discounted—would certainly shock the global economy again and hamper the recovery of the euro zone.

It is also worth noting that retail sales rose by an impressive 14.7% in China during the first two months of 2007 with a consumer price increase of 2.7%. This helps to support the opinions of those that perceive China to be rapidly taking over from the USA, believing it is on track to becoming the leading consumer market in the world and, by consequence, reducing the importance of US consumer sales. However, even if there is some truth in this, the importance of the US consumer market and the key position of the US economy in the global financial markets continue to dominate. Nevertheless, we still feel that people should be prepared for further upheavals in the financial market this year.

Market intelligence

Once again, there has been nothing of great excitement during the last two weeks. The hide market is still in settling mode and most players still saw little need for much movement. This does not come as a great surprise at this time of the year as the production cycle in Europe is now entering the last quarter and, consequently, the final lap. Due to the longer lead times in Asia, many leather and leather product buyers are now circulating in the Orient to negotiate the next round of their leather demand. The GDS shoe fair in Düsseldorf is said have been successful and the outlook for shoe sales and business remained fairly positive.

As a result the market remained in a pretty uninspired mode. While in Europe tanners are buying only what they need to keep production running, Asian buyers are presently uncertain about leather prices for next season and are not exposing themselves too much in the market. The travel season to Asia has started and both suppliers and customers are holding out for their meetings in order to gain insight from the impressions they might offer about the general situation and about the future of the leather pipeline.

As far as trading and activity is concerned, the situation remains the same as it has been for a while, with the minimum turnover per week is still enough to keep the market on a solid footing. Producers and sellers of raw material are still pretty comfortable in their positions so they don’t feel too hard pushed to manoeuvre and favour their clients’ price desires. However, the moderate correction we expected and the loss of dynamic have taken place and tanners can now relax a bit about their supply situation compared with the last quarter of 2006. However, they will have to watch the developments in the coming weeks carefully.

Market slows down after end-of-year peak

Although the fundamentals have changed very little and the basis for leather demand for the rest of 2007 also looks pretty good, it is impossible to overstate how cautious the trade has become. The present situation is a reminder of the cyclical nature of the leather pipeline and is still a decent tool as a general economic indicator.

When the present cycle began in early 2005, only the US economy performed well and the slowly improving situation in the leather pipeline did not create a great deal of confidence in terms of a global economic strengthening. This changed quickly and the strongest performance in the leather pipeline came in the second and third quarters of 2006 when the stream of product in the pipeline accelerated quickly and, as a result, prices saw their strongest gains in the fourth quarter of 2006. Since then the market has lost a lot of momentum and has almost come to a standstill as far as price movements for the standard and average quality hides, such as US and continental European hides, are concerned.

So what happened then? When these hides had reached their present peak levels and, in many cases, disqualified profitable leather production, and it was obvious that ‘more money would not buy more hides’, tanners decided to move on to more economical origins and the demand for standard items slowed down. Consequently, the economical hides, such as Eastern bloc and South American origins, advanced and we have seen price increases of up to 50% in less than a year for certain types. 

Global purchasing power changes everything

That is where we stand now and, looking at the ‘real value’ terms of hides and their prices, we have to deal with the fact that all hides today are more or less at the same quality/cost ratio level and are no longer profitable for the bulk of leather production. In the past, the cyclical effect has kicked in at this point and either the demand for leather declined for price reasons, articles changed or leather was simply substituted for other products. So why should this be different now?

Well, we now have to deal with a massive increase in global purchasing power. In the past, demand was almost exclusively determined by the three big consumer blocs: the USA, Japan and Europe. Only these three regions had enough purchasing power to change fundamental demand either for price or for fashion reasons. This has completely changed, with growth led by China, India and Russia with South America and the rest of Asia also experiencing strong growth, and so the balance and influences are completely changing. We draw our readers’ attention to the 14.7% rise in Chinese sales once again.

This also makes planning, forecasts and predictions more difficult. The business world still lacks transparency, reliable statistical data from the emerging markets and, most of all, knowledge about consumer reactions to price and fashion changes. This is the junction at which we currently stand, despite all the turbulence in the financial markets and all the theories about the development of the economy in the USA, Japan and Europe. In the end, there is no great risk that demand for leather products will be hit too hard or that it will fail to find compensation from the growth of consumer purchasing in the emerging markets.

Survival of the fittest takes toll on struggling companies

While growth in the global leather industry is limited by the restricted raw material supply, the most important issue for companies is price or, more accurately, profitability. Just as important as our discussions about tanners’ margin problems since raw material prices have increased is the recognition of the very healthy profits of retailers and marketers of shoes and leathergoods in 2006. Those integrated manufacturers who combine production and marketing are particularly thriving with even better results on the whole.

If the assumption that raw bovine material supply does not grow significantly, global demand for leather products does not decline in the short term and marketers’ and retailers’ profits are much higher than those of manufacturers and integrated operations is correct, the consequences are obvious. Following the ‘survival of the fittest’ theory and considering that the allocation of resources is eventually the same, one can have very little hope for the tanning businesses that are currently operating at a loss or without a sufficient margin. Following this logic, supply and allocation is going to be at a bottleneck for some time and this puts the weakest in the community at the highest risk. Consequently, there is little chance of a long-term price cycle of lower levels in the short term, which has always provided an opportunity for recovery in the past.

We have to stress that we are just trying to provoke our readers’ opinions in order for them to analyse their own positions. If we can help by adding a few thoughts into the mix then we have achieved our aims. We will always see short-term price fluctuations and there will also be cheaper prices at some point this year but the fundamental point is that those businesses that are operating in the core production of consumer goods, particularly shoes, would be well advised to protect their positions by focusing on the supply side, while the others should carefully consider whether they can win the battle against the challenges of rising production costs, price competition and raw material supply, and whether their profitability is good enough to take on further battles. We reiterate our opinion that leather business is merely undergoing a normal restructuring process and is going through the same realignment that other businesses already have behind them.

Goats and garment nappa looking up

The skins market has also taken a break. However, goats seem to have benefited from the situation and many are expecting goatskin prices to rise in 2007. The outlook for garment nappa is also improving as at least those in the fashion industry are supporting the product. Whether the consumer will do the same will become clear when the spring sales are over and the autumn collections are in the shops.

The splits market is still problematical and many tanners are complaining that sales and marketing of splits is becoming even more difficult. With the end of the winter season in the northern hemisphere, the demand for food consumption from splits is also slowly decreasing. If suede and by-cast are not repopularised within the shoe industry it could turn out to be another difficult quarter for splits.

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