MARKET INTELLIGENCE – 09.06.07

Macroeconomics

The situation in the international financial market has livened up a little in the last few weeks. Rising interest rates, volatile stock markets, concerns about future rates and the G8 summit in Germany have given investors sufficient reason to reconsider their investment policies.

The ECB raised interest rates by 0.25% and is expected to continue its tightening policy for the remainder of the year. Most market players believe that two more 0.25% increases are to be expected. In response to increased interest rates in Europe, bond yields also rose in the United States, and treasury bonds jumped more than 5%.

Investors are increasingly concerned about the risk of inflation and have decided to cash in profits from their stock market investments as most leading bourses corrected sharply last week and dropped by as much as 6% to 8% within a few days.

Regular readers are well aware that we are seriously concerned about inflation and it appears that the potential risk is now gradually moving into the foreground in the markets. So far, few people are showing a great deal of concern and most investors and analysts are simply talking about healthy corrections, but there is no question that the level of risk continues to rise. New wage contracts in Europe are pushing labour costs even higher and we are still anticipating the consequences of rising commodity prices in the consumer market.

Looking at the development of commodity prices over the last year, we still see double digit increases in most segments and the thing that has worried us most is that, according to the Economist, the index for food prices over the last 12 months has risen by 23.5%. Adding the sharp increase in energy prices, we can see how significantly the core expenses for a normal family have risen, leaving far less for money to spend on other consumer products. We are not sure about further developments for energy prices, but the trend for food prices will definitely increase further as we explained in previous issues of the Market Intelligence report.

The $ managed to extend its gains versus most other currencies, which is mainly a result of unwinding carry trades rather than a significant increase in optimism regarding the future of the American economy. With rising inflationary pressures, investors are at least considering the potential for rate cuts in the United States to be less probable than a few months ago. It is questionable whether the $ really has much more room for correction, but perhaps European exporters have a better chance of covering their revenues for business in the $ over the summer than they had in their budgets set at the beginning of the year.

Market Intelligence

As far as the general market environment is concerned, the last two weeks have not offered much news or direction. Consequently, most of the ‘insight’ contained in the report two weeks ago could have been copied into this issue.

There is still no sign of a sharp downturn in purchases, although the corrections and the differences in the situations of the various market segments are completely different. The seasonal decline in shoe leather production is still hitting the market hard, as is the shift of automotive leather manufacturers away from the standard items obtained from the United States or Europe to lower price materials in South America.

In addition, the performance of the European upholstery leather manufacturers is pretty low and the reports one can obtain from the centre of production in Northern Italy reveal a high level of depression. Locals are suggesting that they have not seen such low activity for quite some years.  Looking at the time of the year and the season, there is very little hope of improvement until the summer break, at least for the European upholstery manufacturing sector.

Calf skins complete their cycle

Another high flyer in terms of leather production is also struggling. Extra light calf skins—a typical cyclical product—was already facing significant resistance around the time of Lineapelle at the end of April, but it has now almost gone into freefall. Prices have already decreased by 25% to 35% in the last three to four weeks and this has been pretty terrible for those who did not have long-term contracts and needed to move some product prior to the summer holidays.

This was more or less a market classic as the small calf skins have undergone almost a typical cycle over the past years. Having been removed from many leather collections, they started their price move at almost half the price reached during the peak period towards the end of 2006. The pattern always starts in the same way. Prices for the raw material are reasonably low and production is confined to a relatively few suppliers who produce the material, year in, year out. Due to the high quality and the reasonably low price, designers ‘discover’ the product again and put it back into their collections, which sell well. Other brands jump on the bandwagon trying to find leather suppliers in the leather industry and tanners, who are desperately looking to upgrade their production, also enter the raw material market, and so the cycle starts. With increasing success, more players start to fight for the limited supply of the special product and the price spiral moves on. When certain price levels are reached and the last producer or brand has jumped in, the early ones are disappearing and, when the commitments from the seasonal collections come to an end, the demand suddenly falls rapidly, leaving only the standard producers with their specific products in the game. In summary, prices climb over a longer period and fall in a pretty short one.

Even many of the luxury brands have asked their suppliers to find cheaper alternatives and this has significantly reduced demand for the specific calf skin leathers for the time being and, most likely, for the next season.

The key question we started discussing in our last issue, and which is now becoming a daily topic of conversation, is whether the situation we have described above could give us an idea of what is going to happen in the second half of 2007, and also in the bovine leather market. Well, the two markets have very little in common and so it could really just serve as an example.

The bovine market is different as it has many more alternatives and the perspective is much wider. However, there are also cycles that apply to the leather pipeline in general, as we have mentioned many times before, and one has to have a long term perspective. From our last report, many of our readers are aware that we are still not particularly concerned about the state of the market. Looking at the present situation, we have to at least discuss the possibility of a fundamental change in the market trend and we have to admit that the probability of a change has moved from level four to level six on a scale of one to ten.

Where are the accumulated inventories?

The key question we have to answer over the next six to eight weeks is whether there are accumulated inventories along the pipeline. Some of the speculation suggests that Chinese tanners in particular had already produced for stock in 2006 and into 2007. Some are saying that the reason for this is the change in the Chinese tax policy, while others assume that it was related to the fantastic outlook in the leather business and the speculation about higher raw material prices. As far as the speculation is concerned, the players may have been right, but the profit is only locked in when the leather is sold not only on volume but also at the prices the seller has in mind. And production also has to continue. In the end, you have to be able to sell more than you actually produce to get rid of the product sitting in your warehouse.

Regardless of whether large stocks of wet blue, crust or finished leather might be sitting somewhere, we think that the main answer has to come from the consumer markets. So far, the consumer has not reacted to rising interest rates and the effect of rising food and energy prices. The growth in the emerging markets and the steady conditions in most of the old economies generated confidence and sales that were far higher in the last 18 months than ever before. We believe there could be a possible slowdown in consumer spending, but from what we can see today, there is no reason to believe that this will be significant enough to actually harm the leather pipeline in a dramatic way. We are fully aware that this is all some kind of theory and it implies that the leather pipeline is in a normal and steady flow.

And this is where we are forced to return to the question of whether there are inventories sitting along the production chain. Retailers should be pretty well cleaned up as hardly anyone related to the sale of leather products has not experienced double digit sales increases in recent seasons. So, at a retail level, there cannot be much product sitting. Furthermore, there can be little accumulation in terms of raw materials, at least for the time being, despite the fact that the situation is no easier or more positive than it was some time ago. Consequently, inventories can only be located at the production level. Following the strong retail sales, one can hardly expect much at the leather product manufacturing level either.

So, we are more or less left with the tanning or wet blue level. What do we know about this section today? Well, most of what we know is simply rumour. Looking at exports and shipments, at least until today, there is no real sign of a serious decline. Many tanners keep their beamhouses busy and talks about delayed L/C openings and shipping delays might be more market rather than production related. So, where could these materials be stuck? Well, reports from Northern Italy mostly reveal full warehouses and we have already discussed China. In Brazil, reports indicate that the better grades are not moving in the same volumes in which they are produced, and in Europe there may be a number of heavy hides parked in wet blue because they did not move in raw.

We do not want to sound overly optimistic but, considering the season, we cannot see anything unusual as the (possible) stocks do not really look like a big threat considering what we have seen in the past and, with a fundamentally positive outlook, there is really very little to cause serious concern.

The market seeks a trigger

The problem is that many in the business are still not operating according to rational assessments. What we have to watch carefully today is psychology and the domino effect which could take place. Many are expressing concerns that the situation has been too good for too long and that, consequently, it must be about to get worse. This is mixed with the general margin problems of tanners who are traditionally convinced that only the raw material market can solve their problems. So a good number of the market players have just been waiting to collect enough arguments to give them the courage to follow their hopes and opinions. On the other side, sellers always tend to wait too long and, since we are on pretty decent price levels for raw material, there could come a day when raw material sellers start to fall over each other in order to secure price levels that could one day appear attractive. So, as we already said in the previous issue, sometimes all that is needed is a trigger and you never know where that will come from.

So we must now watch the volume market very carefully, particularly in Brazil and the United States. The domestic Chinese market, which is still pretty expensive these days, must also be monitored with great care if a sudden avalanche in prices is on its way. Fundamentally, in terms of psychology, we cannot expect that the mood will definitely get worse and, with rising interest rates and another sharp decline in the stock markets, nobody should be surprised if this spills over into the leather pipeline. It has always been a reasonably good indication of the general economic trend over the past two years.

Splits and skins continue to struggle

The splits market is not getting out of the doldrums. Some specialties, such as very cheap or very heavy material, are still finding homes and customers, but when it comes to the standard production in the range between 1.5 and 2.5 mm we couldn't find anyone who was not fairly depressed. With the summer ahead of us, only speculation could support this market as far as we are concerned.

There is nothing new in the skins market either. Big skins with good wool are still selling well in China and skins that can substitute calf and are of acceptable quality are also finding homes. A bit more activity for the new season double face skins has been seen from Turkey but, in general, one couldn't say that there is any steam in the market. Everyone in Europe is now waiting to see how the traditional double face skin buyers will behave over the summer period and, with prices hovering around the €5.50 per piece level, it is unlikely there will be much change. Those that still have some cheap stocks of low grades or shearlings available will now find it much easier to move them.

We believe that the next four to six weeks are likely to offer far more indications of where the market will develop. It seems that some grades are still in a correction process. Some US steer types, lower grade cows and—at least as far as we are concerned—Brazilian hides should be named as potentials. In particular, the Brazilian TR1 and 2s are, in our view, far out of the global price range and have a decent potential for an adjustment. Although we would still just consider this to be a correction of overvalued material, we have to watch whether this could be the trigger and drag the entire market levels lower into the summer which would then become a real trend which started right after APLF in Hong Kong. For the profitability of the tanning industry, a slide of raw material prices over the summer would be the best possible solution as it would increase margins and offer more adequate raw material prices for the start of the new production cycle starting after the holiday break.