Macroeconomics

The financial markets are becoming more volatile. Firm oil prices, yo-yoing stock markets, concerns about inflation and risks from hedge funds have been the main focus. The majority of players are still trying to paint a bright picture of the stock markets and investment opportunities but, as mentioned before in this situation, one has the feeling that more and more are at least preparing their exit.

Food prices continue to rise and this problem, which has been ignored for a long time, is now quoted almost daily in the media. Companies producing food products are already complaining about the rising cost of milk powder, butter, wheat and so on. Oil and petrol prices are also climbing, partly due to refinery shortages, but also due to the classic annual ‘pricing policy’ in the summer season when holidaymakers are taking their families away to the beach or to the mountains. Meanwhile, money is becoming more expensive and yields around the globe continue to rise.

No matter what the financial experts say, life is becoming significantly more expensive for normal consumers across the world, and this will particularly take its toll on the ‘old economies’ in the end. So far, the mood tends more toward the positive than the negative, but we believe that the situation should be taken seriously considering late 2007 and 2008 budgets.

The $ has ended its stronger performance against the €. Rising fears about the future of hedge funds and the housing market are weighing on the greenback again, while the outlook in Europe remains more positive despite a moderate decline in Germany’s IFO index, which surprisingly fell by a rough point in June.

 

Market intelligence

While May and the first half of June did not deliver much serious news for the leather pipeline, we have to say that the last two weeks were much more interesting and the general picture is slowly clearing up.

In our last issue, we discussed the difference between the psychological sentiment and the fundamental and rational facts, and came to the conclusion that psychology could presently be a stronger factor than the facts. This is combined with another scenario we described last year that may have already been forgotten.

Some may remember our warnings—which perhaps came too early—that the combination of high raw material prices, sharply increasing production costs and (in Europe) the weaker $ would have a very negative effect on margins and cash-flow positions. This seems to have become a reality now and is having an increasingly heavy impact on the market and budgets.

Financial and company results are still one of the biggest secrets in the leather pipeline, at least up to manufacturing levels. Smaller- and medium-sized companies are mostly still run by families or sole private ownerships and are traditionally not willing to share much detail about their results with the public, whether they are good or bad. So, it remains difficult to obtain a realistic picture of the industry’s situation.

 

Closer monitoring from banks and creditors

In the past, controls implemented by banks and tax offices caused reasonable delays in presenting results and balance sheets. This allowed for a lot of playing about with stock valuations, sometimes in order to hide the truth and to use the next favourable market trend to resolve some of the earning problems. Nowadays, it is not as straightforward, as banks and credit insurers run much tighter risk managements and there are basically much lower inventory levels to play with. The companies working with bank loans—and this will include the vast majority in the trade—are also monitored much more closely in terms of their short-term operating results.

Considering the market conditions over the last six months, we have to accept that margins in the pipeline up to tanning level must have deteriorated significantly, as this part of the pipeline, excluding abattoirs of course, had to absorb most of the negative effects of material cost increases. By mid 2007, most of the 2006 results are available to banks and credit insurers and this explains why, in the past few weeks, a number of rumours of delayed payments and credit insurers cutting their covers on a rising number of companies are circulating. This mainly applies to the European market, but would also explain the information about delayed letters of credit from Asia.

 

Profitability issues begin to surface

However, we are still seeing good, and even record, results at the consumer product manufacturing and retail level, with only one exception—companies with management failures or structural problems. Since the industry’s first steps still have not generated the size and market power to secure sufficient margins, the sizes at the beginning (beef production) and the end (consumer product manufacturers and retailers) have reached levels benefiting from their sheer market power, at least until today.

So we are now seeing hardly any sign of a slowdown in the global demand for consumer products, which would justify the present market correction for raw materials. However, problems with profitability at trading and tanning level with their consequences on cash-flow and market power are now starting to run their course. We asserted last year that this market will eventually be sorted out by the size of players’ wallets and we now believe this has been confirmed.

What else do we need to mention? Well, the people suffering most seem to be those within the European industry and tanners in China who ignored indications that the government had been giving for some time. While in Europe tanners have been hit hard by increasing costs, almost flat domestic retail markets and the firm €, tax issues, tightening credit resources and more pollution controls are making the lives of the under-prepared in China difficult. Both groups who failed to do their homework in time are, or will be, facing tough times. With the remaining overcapacity in the market, a shake-out would not come as a surprise. Banks and credit insurers, as stated above, will add to developments.

 

Doubts over the peak price period

Has anything changed in the leather pipeline in the past two weeks? Well, the psychological factor has become even more important and buyers have taken more control of the market. The market in the USA is weighing heavily on the global sentiment and, as the only one reporting on a daily basis, it is taken as a reference for the trend as it was when the market was always pushed higher. This is even more important as it is mainly the Asian tanners that are watching the reports, when the reports suit them.

Prices in the US have fallen again and are now about 10% lower than they were during the peaks earlier this year. Only a few other origins or better grades have followed this trend and the extra heavy European hides are important here. While tanners have now taken the 10% as a reference and expect that all other hides should also decline at the same rate, it is still questionable whether the peak prices were ever a realistic market level with significant volumes traded or whether they were simply the result of the courage and the market control sellers believed to have at that time. We still believe that the market has never really reached levels far into the $80s and many will remember that buyers were already shifting into other supply origins and left their key supplying market aside wherever they could. We still remember APLF at which the sign ‘sold out until August’ was hung outside the US stands. Monitoring the market activity and the available statistics, one already had doubts about the situation at that time. Sales statistics never really justified the statement.

With prices now having reached the low $70s, we have experienced a limited correction so far, which could realistically be around 5% if it is based on a volume weighted average of prices. All of the above is an explanation of why things are developing the way they are and whether anything major has already happened. So far, we do not believe it has.

 

Steady leather demand continues

However, the question we raised last time over whether the correction mood could finally be switched into a really weak market still needs to be answered. The best case scenario would be that the slide would now spill over into other origins and end in a decline of raw material prices within a range of up to 10%. The extent would depend on the price levels they have reached and the real value of the hide. This would allow tanners to return to acceptable margins, providing they are able to hold leather prices steady.

Rationally, the market has a fair chance of creating such a solid and healthy development. Leather demand is steady on good levels and, consequently, the tanning and manufacturing industries need regular replenishment and product flow. The market is presently balancing the exaggerations seen at the end of the last production cycle. Costs rising, profitability and cash-flow issues are forcing the raw material market back into its long-term price range, which is still sidelining leather as a manufacturing product when it is exceeded on the upside.

So far, the normal market fundamentals are the determining factors. However, we now have to deal with more psychological issues and these are slowly becoming a stronger factor. After the long bull market, buyers feel that they have gained control of the market again. A flow of negative news, such as the cut of credit insurance cover in Europe, bankruptcies such as the Schieder Group in Germany, reportedly the largest furniture company in Europe, rumours about financial problems among the larger Chinese tanners and rising interest rates and/or tightening of credit facilities are sharply increasing fear and caution. Sellers are threatened further with the usual round of weaker market claims and the risk that buyers are trying to renegotiate their more expensive contracts. This, combined with the upcoming holiday season and buyers’ normal attempts to hit the bottom of the market, is creating a rising risk for further price reductions.

 

Stability to be the main aim

A lot will now depend on the ‘impressions’ the market players receive. Asian buyers are traditionally not good players in a weak market while they are ‘happy pushers’ in a firm market. With Europe approaching the holiday season and the Asians still having a few weeks until they have to make proper decisions about their purchasing needs for August/September, an interesting situation is developing.

In the end, the leather pipeline can only hope for sensible management of the situation. As already discussed on several occasions, the pipeline must focus on reduced volatility. Buyers and sellers should look for stable conditions and this worked pretty well until the exaggerated phase in the first quarter of 2006. There is now a fair chance of returning to a period of high stability and it will depend less on market gossip and more on the private deals of the big players and whether they are able to sit at the table and reach price and quantity agreements for the next two to three months. It is in the interest of both sides to settle the market back into a price range that suits all and, even more importantly, a return to stability. This having been sorted out, the ‘free market’ will follow voluntarily and with great pleasure. As long as demand for leather continues to show little weakness and sensible pricing, and the rise in domestic demand in the emerging markets continues to compensate for slightly bumpier conditions elsewhere, stability is the best outcome for everyone. Excessive price variations would have far more negative long-term effects than short-term benefits.

 

Splits struggle while skins start to recover

The splits market is not really on solid ground yet. There have been some reports of a little more activity, but it does not yet appear to be enough to resolve the structural problems. There is still too much stock sitting around and the slow summer season is not helping the situation. Without a strong return to a fashion that requires the use of splits, it is still difficult to see any light at the end of the tunnel.

Skins are delivering mixed results. Some are performing better; skins that offer a good return on wool are still easily absorbed by the Chinese market and skins that can substitute small and baby calf are also finding homes without any trouble. Double-faced material is still not clear about its direction with the Turkish market neither here nor there for next season. However, the skins market is essentially steady overall and is not facing a similar market environment to hides. It seems that skins have made inroads into leather production and this also explains why some parts of the calf market have been facing stronger headwinds for a while.

 

Thorough planning will be the key

We are now entering a decisive period for the bovine market. Within a time frame of two to six weeks the market will show its way into the third quarter and kick off the ‘after summer’ production cycle. A lot of parameters will now come into play. The market has become more mature in recent years and there is a fair chance that the typical psychological influences that commanded the market so much in the past could be more or less squeezed into the background. Dominant players would be well advised to make a short- and medium-term plan with buyers, setting clear purchasing price levels and quantities to buy into the falling market to create a secure supply of their preferred raw materials at a fair average price. With the corrected prices of many grades, better margins are being offered and building positions into deflated raw material price levels cannot be a bad bet. Picking origins that are under specific seasonal pressure could be even more beneficial. If buyers try to hit the bottom and the market switches from the correction into a bear market, sellers’ frustrations will add to more volatility in the medium term to nobody’s benefit.