Macroeconomics

The general macroeconomic situation delivered some calming news. With most of the focus remaining on developments in the USA, the majority of players were pleasantly surprised to see that the labour market was performing pretty well and welcomed the news that consumer spending in September had beaten the forecasts. Most pundits saw this as an indication that the US economy is not heading into a recession and that the economy could find a soft landing. A better-than-expected trade deficit also eased concerns.

So, looking at the short-term situation, the financial markets began to relax a little towards the end of the last two weeks.

European confidence declines

Unfortunately, the situation In Europe failed to provide the positive impressions that we have been seeing for quite some time. Most polls showed a slow decline in business and consumer confidence in the “old world”. This could also be related to fading competitiveness in the export markets due to the strength of the euro as despite a very strong performance in the export markets — in particular from Germany — politicians and businessmen are becoming increasingly concerned about the high value of the new currency. In the political arena in particular more and more people are voicing concerns about the levels that the currency has now reached stating that the negative effect on exports could outweigh the positive effect of rising import prices.

Although the decision makers at the ECB will not react to political pressure, with levels above 1.40 one can sense that the wind is starting to change. Not that anyone can do anything about currency exchange levels, but the recent news from the USA and rising concerns from Europe might eventually be enough to turn the long-standing weak trend of the greenback around. The key to any major correction will, however, continue to be in the hands of China and its RNB policy and not in front of the screens of the day traders and financial speculators.

The hot topic amongst most of the financial community these days is the question of whether the US economy still has the same influence on the global economy as it used to have or whether the importance of the anchor economy is now fading and lies on the shoulders of those in the emerging markets. Whilst some think that the new Chinese powerhouse will take over in a few years, others are voicing concerns about the stability of the economy, highlighting the lack of transparency and the great dependency on the performance of the property markets and the stock exchanges in China. If there is ever any problem and the concerns of these sceptics are confirmed, we would undoubtedly see a similar situation to the last Asian financial crisis in 1997.

Market intelligence

We would like to start this issue of the market intelligence by continuing the theme of the last paragraph of the macroeconomic section as the Chinese situation had already been brought to our attention some time ago when one of our sources shared his observations from his trips to China. He noticed an increasing number of people in the leather business who seemed to be more interested in property and stock market activities than their main business of producing or manufacturing leather.

He compared the situation with trips he had made throughout Asia in 1996 when he saw more owners watching the stock market developments on TV rather than focusing on important business discussions with their managers, suppliers or customers. Although one doesn't see many TV sets in offices today, this doesn't prove anything as most of this type of business and information has now shifted to the internet and a computer monitor or laptop, which one can find in almost every office.  Even at the fair in Shanghai people reported seeing businessmen paying more attention to their laptop screens and stock market movements than to the discussions with their customers.

An unknown risk

A lot of people in China like gambling and this also includes betting on the stock markets and the fantastic performance seen in the property market has added to the wealth of many. It appears that the impressive growth seen in share prices as well as property prices has also seemingly increased also the risk level. The question now asked by many is whether companies have moved some of their capital to outside investments rather than using it to buy raw materials or invest in machinery and managing their sales activities. By asking straight questions one often gets the same reply which is: “Yes, certainly this is pretty common and I know Mr X and Mr Y who have got pretty rich this way, but not in my business.”

The next question is obviously: Can one really believe that it is always the others? The credit facilities of companies have often been misused and money has been poured into other risky investments.

Anyway, to finish this short aside it seems that where there is smoke there is also fire and having learned a little about the Chinese mentality it would actually be a surprise if there were not quite a bit of truth in these concerns. As long as the stock markets and the property market continue to perform so well we should see very little risk, but if the trend reversed, let's hope that things don't become as ugly as they were in 1997.

The market bides its time

Coming back to the simple and profound world of hides, skins and leather we have not seen too much action in the last two weeks. This was basically expected and with the holidays in China and the upcoming fair in Bologna the leather pipeline was not willing to really indicate any further clear trends for the short-term as yet. The tanning industry continues to ask for low raw material prices and the sellers are starting to become a bit bored with the long-standing weaker trend of the bovine raw material market and have started to discuss the possibility for the market to still see a turnaround this year.

There have been plenty of arguments from both sides being thrown around. It is quite normal that the tanners, who have been able to drive the standard material from the USA and Europe down over the last months, still believe that they are in control of the market and for them it is only a question of how much further and not if the market is going to decline. However, it might be a good time to put together a few fundamentals again in order to evaluate the potential trends of the market for the rest of the year  or maybe even for the entire production season until the second quarter of 2008.

Let’s recapitulate what has happened so far and where we stand as per today.

• With the strong growth of the global economy in 2006 and into 2007 we saw strong demand for leather products and raw material. Margins were healthy in general, the outlook was good and volumes were decent. This created a pretty strong raw material market with steadily rising prices. Tanners did not experiment too much and bought standard materials of known and reliable quality. Cost averaging worked for a longer period — at least until the end of the season 2006/2007. This trend was pronounced by some increased inventory buying in 2006 in China due to the changes to the tax policy of the government which were expected in 2007. This inflated raw material prices from the main supply markets.
  
• Rising energy prices, chemical costs, increasing price competition for finished materials and stronger growth in the emerging markets than in the established regions and the rolling out effect of the tax policy changes in China led to a revaluation of the situation and tanners had to focus on cheaper buying. Better finishing technology, more tolerance in terms of quality and articles to protect against rising finished product prices has seen higher priced raw material declining in price and cheaper, lower quality raw materials rising in price since the first quarter of 2007.

As a consequence, the discussion today is whether the prices for the different price levels have already narrowed enough to stop this trend and possibly to herald a new era of market cycles.

Well, there are a lot of pros and cons for any of the opinions. While prices for cheaper origins are on the very high side of the average, standard materials from Europe and the USA are pretty much around the average and even already slightly below In Europe, but this is certainly closely related to the currency situation.

Yield dominates decisions

The improving choice of technology losing more and more importance for mass production and yield is becoming almost the only determining factor in the calculations. High substance and superior ‘naked’ leather have been pushed into an entire niche and no longer play any significant role in the big picture. Split prices are down and pretty much the same all over. The vast majority of leather produced today is buffed and or embossed anyway or the natural defects are part of the appearance. This trend must actually have been welcomed in a way as it uses the limited raw material in a much more efficient way and the traditional problem of being left with the lowest selection lying around in large or sometimes smaller quantities has been solved for the moment.

We should be happy about this and one could wonder where raw material prices would be if this more efficient use of material had not taken place.

Taking this into consideration and looking at the price structure of today (bad hides are expensive and better hides are subdued in price) one should not underestimate the added cost which is involved in turning imperfect raw material into a decent piece of leather. Furthermore, really cheap raw materials are not always too reliable in terms of supply and the final quality result is frequently still a bit of lottery.

Correction likely to continue

Therefore we feel that the period of correction might still continue for a while, because sometimes the trend feeds itself. But from the simple calculations of raw material and production we believe that the break even level between the two sides is definitely not far away, if it has not been reached already. We would even go so far as to say that cheap raw materials are overvalued at present considering the return that they offer.

We wouldn’t say that prices are ready for a sharp turnaround as the pattern of global consumer product markets would not really permit that at the moment, but, the downward pressure should fade rather quickly now. This is on the condition that the global economy does not derail as due to unforeseeable reasons the supply of raw material could quickly become an issue again when the global production cycle gain speed again in the winter semester. There are indeed still traps on the road. We have given a warning that we could see some trouble from the cash flow situation and we were not too amused by rumours that one of the larger Italian tanning groups can no longer be credit insured and we have also already mentioned the risk situation in China above.

However, under normal conditions, demand should now gradually increase as sellers have been following the market over the past months in a rather risk averse fashion and opted for the traditional policy of ‘position before price’. We have to believe that the export sales and statistics from the USA have never fully considered cancellations or renegotiated contracts which certainly resulted in delivering a wrong picture, but this should also be sorted out finally so the long-term thinkers and established buyers with a decent overview of their production plans for the coming six months can value their position in the market for the rest of 2007.

Splits and skins largely unaltered

The split market remains pretty much the same as it has been for some time: difficult to move product for leather production and a slow but sure rise in interest in collagen and gelatine production. This doesn’t help tanners’ calculations much, because the prices for this kind of material can never compensate for the needs of tanners, but at least the product flow is still guaranteed as long as you produce lime splits. We are very interested to see if more split articles will be seen in Bologna and if fashion is going to allow splits to return into production.

The skin market continues to pretty much reflect the hide market. Whatever carries wool, is over 7 sq. ft. and less than $5 is snapped up the moment it is offered. If it is between $5 and $7 tough negotiations are required and above this it gets pretty difficult. The market is still being influenced by the FMD situation in England and whilst exports to most countries are open again China remains closed and this is causing a bit of trouble. A number of skins which should have gone to China are still circulating and have either been left stranded and/or need to be resold. This has caused prices to drop and is leaving other markets a fair chance to secure good quality skins at pretty reasonable prices. Nappa leather demand remains in good shape and interest in larger skins for shoe and bag leathers too is offering tanners good selling opportunities outside the garment business. Interest in double-face is still not what is should be and demand for European double-face skins was lower than it should have been over the summer.

All eyes on Italy

The coming two weeks will be mainly influenced by the fair in Bologna which is always pretty important for the industry in autumn. Although we are still concerned about the general outlook for the global economy and the current cash problems, it seems that the demand for the next season is still strong enough to maintain the same production levels as seen in the last one. Reduced inventories, the sharp rise in prices for economical hides combined insufficient supply of the same are starting to build a solid base for the rest of the market. It may still be a little premature for the final settlement, but it might be better to deal today with the potential situations of tomorrow.

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