MARKET INTELLIGENCE – 27.04.07

Macroeconomics

Some weeks ago, we were complaining about the reasonably quiet financial markets which did not appear to offer much guidance or data for the general market trend. However, this has changed drastically in recent weeks and the lack of excitement has, in our opinion at least, turned into over-exuberance. The question we are now left with is which of these new developments is the most significant?

Is it the fall of the $ which ended just short of the all-time low against the €? Is it the fascinating recovery of the global stock markets which is being driven by hedge funds and speculation of takeovers? Is it the strong and sharp recovery of the euro zone, led and dominated by the biggest economy, Germany? Or is it a combination of all these factors mixed with impressive corporate results?

One thing is obvious. The global community is once again pushing concerns and potential problems further into the background and appears to be intoxicated by the strong recovery of the financial markets and the current excess liquidity.

Issues that would normally cause concern are presently going unnoticed. This includes the threat of a Chinese economy that could easily overheat (+11.1% in the first quarter), growing instability in the Middle East, imbalances in the USA and the uncertain outlook for the economy, and high raw material costs.

In the meantime, the $ halted its descent just short of 1.37 before rebounding a little. Oil continues to trade in the mid-$60s while the chaos in Iraq continues and, whatever decision is made by the USA as to whether it should remain in the country or not, the problems there will not have been solved. Furthermore, Russia’s decision to suspend its participation in a key arms control treaty has not come at the right time and is not going to be helpful in terms of global stability at the moment.

While in Germany consumer confidence rose to 5.5—the highest level since the 1980s—the outlook for the US economy remains unclear. While the beige book is showing moderate growth, consumer confidence and the housing market are still delivering pretty mixed results. The financial community feels that the hike in interest rates has come to an end and that the next move is likely to be down rather than up, which has sent the Dow Jones Index to new all-time highs.

Most corporations and retailers that have published results recently have again delivered very positive figures and European companies seem assured that the weak $ will not to harm their positive outlook for 2007.

Market intelligence

The last couple of weeks have been divided into two separate chapters. While the first still offered some excitement with Lineapelle in Bologna, the second was largely dominated by distress and holiday preparations.

As usual, the global business almost shuts down after the Hong Kong and Bologna shows. The holidays in Asia and a number of isolated holidays across Europe at the end of April and in May combined with nice weather means that business activity slows remarkably. Apart from these shows, a few others such as the furniture fair in Milan, several aircraft interior shows and FIMEC in Brazil also took place and had a certain impact on the leather pipeline in one way or another, although one cannot say that any of these events resulted in a negative sentiment. The general consensus was that there are concerns and isolated problems that need to be dealt with, but that the fundamental trend of the business remains positive and intact.

In terms of the leather pipeline in general, Lineapelle was probably the most important of all the fairs as an indicator of trends in the leather business. Despite the fact that it is actually only a pre-selection designed to show new trends, it still attracts a large number of interested visitors who wish to check the business climate before going into the long summer break and before the next larger show in Shanghai at the end of the European holidays.

Concerns abated at Lineapelle

Those who made the trip to Bologna were given an impression of how sensitive the market situation is. With a correction having been in full swing since Hong Kong, many were worried that the next get-together could accelerate the downward trend in the raw material market. Visitors that arrived in time for the first day of the show were certainly a little concerned when they realised there was hardly anyone around. The exhibitors were more or less alone and, at lunchtime, only a handful of visitors could be seen in the aisles. At this point, people were pretty worried and comments about the market were mainly negative.  

However, by late afternoon, the number of visitors started to increase, as did the quality of discussions and so, at the end of the first day, people began to relax a little. On the second day the situation was almost completely different. Although some were still talking about there being fewer visitors than in previous years, hardly anyone was really complaining about the number and even fewer were criticising the quality of visitors. By the end of the second day, everything had pretty much normalised and discussions focused more on individual problems rather than general concerns about the future of leather demand.

The last day was traditionally much quieter but the relaxed atmosphere continued and, except for a few isolated cases, most participants returned home with a more positive feeling than that with which they had arrived.

Those expecting very new leather trends at the show were, however, disappointed. For the shoe and leather goods industry, metallic looks and patent leathers were plentiful. This is a normal development in the leather cycle with calfskin prices remaining very high and the continuous demand from manufacturers to offer cheaper alternatives. Tanners generally use this opportunity to get rid of their lower selection at a reasonable price, or to make substitutions, at least for smaller material where goat and sheep can be used in part. So, at the end of the cycle these styles always dominate and, as a result, the top quality raw materials always suffer.

Top grade material affected

Very small calfskins suffered the first hit, dropping by up to 10% with some suppliers becoming nervous before the summer break and buyers seizing the opportunity. The situation was quickly defined and sellers had few options as they could either accept the offers or hang on to the product and hope for better times after the summer holidays.

The story was similar for extra heavy hides. Their plight has been mentioned in many of our reports and the driving forces behind these categories—the automotive industry and the vegetable tanners—again stated that they are neither willing nor able to afford the present prices levels. So, the price descent for these materials continued, although price corrections were not as sharp or extended, and both buyers and sellers have their reasons for wanting an orderly and moderate decline until adequate levels are reached. Sellers obviously do not want to be hit by a sharp drop in prices and buyers do not want to endanger finished leather prices when their customers hear of a substantial drop in raw material values. So, the descent continued and both extra heavy cows over 40 kilogrammes and bulls over 50 kilogrammes faced a further drop of 3%-5%.

The picture for the rest of the standard grades was much less clear. No one had been expecting the 2006 rise in raw material prices to continue, but opinions as to where the market is heading are starting to drift apart. Hardly anyone would deny that the correction we were expecting some weeks ago is now in full swing, but there are questions over whether a new trend and new trading levels well below that of the last six months will be established.

Supply expected to drive the market

Of course, buyers and sellers are seeing this from conflicting points of view. With the present problem of profitability in leather production, tanners are hoping for a reduction, while sellers and, even more so, producers appear convinced that the present decline is simply a correction in a bullish market. Neither side has sufficient arguments to convince us and both points are pretty strong.

We are still confident in our position, which may be somewhere between the two. The market is in a correction phase as leather prices did not follow the raw material and cost increases. We are in the second quarter where business traditionally slows down due to a change in season in the footwear industry. The European tanning industry is in the final phase of production before the summer break and this normally leads to a slowdown in activity. In general, tanners are just trying to make it to the holidays and are not willing to take any additional risk—at least not at the price levels we are seeing. So, any additional support for the demand side in the near future could only be derived from a possible hike in leather demand or in leather prices. In our view, neither is likely to happen.

So, it is more probable that the market will be supply-driven. While in Europe supply is not going to be a great seasonal issue and it is more likely that the kill will remain lower rather than higher, others in the supply market will produce at steady levels, perhaps with the exception of Australia, where the drought could have a short-term effect either way.

All eyes on the USA

Since the USA is still the market maker, we need to focus on that part of the world. Reports from the US market over the last few months have given the impression that the world is a little misguided. Until the fair in Hong Kong, the general indications that they were giving were: all sold, long forward positions, easy and regular shipments, we control the situation and demand outstrips supply. Those who have been reading the USDA export statistics carefully since the beginning of the year have had a gut feeling for quite some time that these reports might not be reflecting the reality. But, although they might not be a reliable indication for the week-to-week business, the numbers reflect the long-term reality quite accurately.

The number of sales and export shipments did not coincide with the tone of the reports written and this has been the case for quite some time. This was particularly the case for the steer market and what we have seen over the past week was that the poker game that sellers had been playing was lost and that tanners, particularly from China, moved successfully into other markets (such as Brazil) thus avoiding further strangulation from the standard supply market.

The key question to ask now is what are the consequences? As mentioned above, the US market continues to be the leading indicator. It was the driving force for the firm market and triggered the upward spiral of all the other origins, and it will remain the stimulus for the next move. This makes it quite difficult as we have a weak $, which is an important factor for the emerging markets, and one still feels that the market information from the USA is still somewhat coloured by the sellers’ interests. This suggests some potential for another downward move.

On the other hand, it is quite obvious that leather and hide demand is still in good shape. A significant hide accumulation cannot be recognised in any of the larger supply markets except the uncertainty for America. Without an accumulation of material it would not be normal to expect a further sharp decline. However, psychology is also a factor. With the levels we have reached, the trade is becoming increasingly nervous, as we saw on the opening day at Lineapelle. Less in response to the fundamentals than to historical experience, sellers are being sensible because they know the way down is far further than the way up and this always puts them on high alert, looking to get the next production period sold.

Bleak outlook for splits

The splits market was another segment where things did not look too good. Despite the logic that with high hide prices splits should gain attention, most splits sellers were not too happy and reported a lack of interest and falling prices. This is hitting the normal standard splits for shoe leather more than the specialties, such as the very heavy substances or very light, top quality ones. The fashion trends have also shown few ‘split-friendly’ articles so we cannot expect to see a rapid turnaround in the splits market.

The skins market has been supported in some segments by the strong performance of the wool market as well as by a growing substitution of small calf for sheep, hairsheep and goat. If this trend persists, it should continue to help the skins market in the coming months.

So, what do we make of all this? We think that the market has made the most of its corrections already, but will still undergo some further and local adjustments. Leading up to June we could still see pressure on the market without too many movements in price, apart from local adjustments as already mentioned. While some grades such as dairy cows look reasonably settled, some ‘overpriced’ steers may still have room before they finally bottom out. However, another 5% should be the maximum movement in most cases as nobody ever really hits bottom.