Market Intelligence - March 25, 2008
25/03/2008
MARKET INTELLIGENCE—24.03.08
Macroeconomics
Over the past two weeks the financial markets have continued to deliver further horror stories and the contents could be become easily the basis for a Hollywood movie when it is all over.
Almost daily new rumours about financial difficulties for banks were circulating. In one case an investment bank of a once good reputation had to be sold at $2 per share with governmental guarantees in support just to save it from failing.
Ruthless speculators are spreading rumours around to make short sales profitable and bankers are still keeping most of their investors in the dark about the real situation and risk exposure of their institutions.
Leading private bankers in Europe are calling for state intervention to prevent the system from collapsing– this is the same people who have strictly out ruled any governmental intervention in the free market in the past.
National banks still need to inject billions into banks and into the market in the hope of rescuing the situation from derailing, and investment funds from Asia and the Middle East are still sitting on the fence to see what good investment opportunities might emerge in the financial system of the old world.
In the US, still the only answer the Federal Reserve has is to lower interest rates hysterically. What this will do in the first instance is help those who created the whole mess in the first instance, the people who have taken all advantage and now run away from the consequences. Only in the second instance—if at all—will this bring any relief for those who are suffering most from the present situation. One can’t help but form the impression that the FED—if it is anything—is not an independent institution. Anyway, it is what it is, and it is certainly trying to bring jobs back into the US by depressing the currency. It remains to be seen if this is also the way to finance the country’s budget.
In the meantime the dollar fell to more than e1.59 before recovering a bit to finish the period at levels around e1.55. The market expected a rate cut of 1% instead of 0.75% and sold the dollar in lower volume after the decision. Hard commodities such as gold and oil dropped by almost 10%, and if speculators decide to pull more money out of commodities against dollar-speculation, we could still see a bit more of the same.
The fear of a recession could also quickly add to the trend and, as we believe that a decent percentage of today’s price levels are based on speculation only, this would support the position we mentioned a while ago, that commodity prices could fall significantly. In the end, if this happens, it would probably be the best thing for the global economies.
In the meantime we still see inflation climbing. In the US there is a rate of 4%, even when the core rate is still quoted at a rate of 2.3%. In the Euro zone the number is also above the desired 2%.
The Tibet conflict is in focus politically and this is causing concern among western democracies. Many are discussing a boycott of the Beijing Olympics but politicians and business leaders are staying out of the debate, knowing that decisions of this kind would have dramatic economical consequences, which nobody would want to risk alone.
Market intelligence
The market focus in the last two weeks shifted even further in the direction of supply markets that base themselves on the US dollar. The export sales reports from the US came out at pretty impressive numbers—with sales for 2008 already exceeding those of 2007—which came as a surprise to many.
On the one hand, this confirms that the leather business globally is more robust than most pessimists believed. But on the other hand, we should not overlook the influence on these numbers of currency changes and the decline of the dollar. We well remember that in the first quarter of 2007 most European suppliers, for example, enjoyed a very strong performance globally until (unjustified) price rises and the declining dollar made their dreams go ‘pop’ like soap bubbles. The price adjustments these markets made were, in many cases, insufficient and came too late.
US suppliers played their cards pretty well, holding prices pretty steady and watching as the competition became automatically more expensive and unpredictable with the fall of the US currency. So the recent numbers are not really a surprise to anyone; the US suppliers have done a good job not to give in to the traditional reflex of raising prices in immediate correlation with sales volumes. The traditional advantage of the US hides of being of a reasonably uniform standard and in abundant supply adds to their position.
The rising activity of the past weeks is in line with normal market development for this time of the year. We questioned in recent Market Intelligence reports if, with all the uncertainties in the global economy, we would see normal development this year, but fortunately leather demand is still strong enough to make (Asian) tanners replenish their inventories, despite all the bleak news.
Higher activity does not resolve any of the structural and fundamental problems of the industry at the moment. Being a tanner in some parts of the world isn’t any fun at the moment and we are still of the opinion that we will see a number of production sites closing down.
The biggest problems have been mentioned a number of times. Europe where the weak US dollar, rising administration and bureaucracy, environmental issues, labour and the lack of a manufacturing customer base is making leather production difficult again. However, a number of production sites in the shooting star of the new millennium, China, are also in serious danger.
Having said that, everybody knows that all the leather needed is always produced, and there is little sign that leather in general could face a serious decline in the short term.
Even if we assume that we are running into a serious economical slow down in the US followed by Europe, and even considering that this will affect production in China, India or Vietnam, it will not decrease the global demand for small-ticket items such as shoes. It may even be the reverse. In difficult times people may buy fewer cars and less upholstery, but small-ticket items such as shoes, bags and leathergoods can still be the little bit of luxury or pleasure that consumers permit themselves.
These goods still account for more than 60% of global leather production, and all the leather required to make them will be produced.
Nevertheless, product flow is not reflecting evenly the supply of raw materials and current demand for leather and finished products. Leather production is still a pretty fragmented business, and not only as far as the size of the producers is concerned. Place of production (transportation time), fashion, seasonality and influences of the financial markets have strong short-term effects on prices and demand without changing the general fundamentals of the pipeline.
Looking back we had been of the opinion, that the recent market development has only been a correction of previous exaggerations, although suppliers outside US dollar areas might not agree when they look at the steep fall in prices they have had to endure over the past three quarters.
Looking at prices in US dollars, however—and this is still the general market currency—global hide prices have only corrected themselves within a range of 10%, which can only be considered as a normal market fluctuation. Since the decline of the dollar has been a persistent and longer-term trend, accelerating since the first quarter of 2007, the market ‘feel’ might be more negative for many than it really was. We had to deal with breathtaking movement in the market after the sharp rises that occurred as a result of an extremely positive outlook for the global economy starting from the end of 2005.
The above still leaves questions about how the market is going to proceed from here. Is the correction over and has the deflation of prices been so extensive that we could now be at the beginning of a recovery? Have the past two weeks in the US already been the start of a new trend, and raw material prices are preparing for a rebound, starting in the US and in other markets that base prices on the dollar?
As usual these questions should not be answered by gut feeling or wishful thinking—neither is anyone an oracle. Whoever needs to make decisions on this subject must take them on their own and be responsible for them.
With this in mind, it could be a good idea to collect again all the pros and cons.
Let us start with the cons, as they might deliver the dominant impression at the moment.
It is the view of most independent research organisations and of the general public that the US economy is heading for a recession, or at least stagnant economical development for a number of quarters.
The weak US dollar and the trouble in the US economy could eventually hit economies in Europe and in some of Asian exporting countries too. The dollar will continue its steep fall against other currencies and is losing its status as the world’s anchor currency.
Inflation will remain an issue unless there is a sharp drop in commodity prices. Meanwhile consumers are facing high energy and food prices. There will be price-rises in other consumer products in 2008 as a result of the effects of the rising cost of raw materials in 2006 and 2007.
There are still a number of raw material stocks in hides and skins which are stuck in the pipeline and which need to be absorbed before supply shortages can force tanners to pay higher asking prices.
US slaughter is going to rise as we move into spring and summer in the northern hemisphere, while leather production is set to slow down in the second quarter owing to seasonal influences.
Structural and cash-flow problems in the tanning industry can still lead to bankruptcies, which would depress the raw material markets until the structural changes are finally resolved.
The massive amount of splits and their low value offer significant protection against a sharp rise in prices for hides and grains, because manufacturers could use splits rather than allow prices to advance sharply.
The crisis in Tibet is going to weigh on international trade relations with China and also have a negative effect on the Chinese economy in general. Unrest is going to spread into other parts of the country; the rural poor across China will take the opportunity to display their anger.
On the bright side
As far as the pros are concerned we would list the following.
The global beef industry is still consolidating. Further takeover activity of Brazil’s JBS has created a global group killing more than 80,000 head per day. Rumours are swirling around the beef business that more consolidation is ahead; some are weighing up their chances of selling, while others are contemplating buying. Stronger units will take action to raise average product prices using their selling power.
Hide and skin prices are traditional front-runners and are normally between six and nine months ahead of general economical development. We have seen a good example in the recent past. Economies are going to stabilise in the second half of 2008 and hide and skin prices are starting to reflect this already.
Global interest rates are falling further. The US dollar interest rate has already fallen significantly and allows dollar-based producers to increase their inventories again, which they let fall when interest rates rose.
The US dollar will recover modestly because of a narrowing gap in interest rates and the hope of recovery in the US economy in late 2008 and 2009.
Falling commodity prices will free cash resources and reduce production costs.
A reduction in available disposable incomes will reduce consumers’ appetite for big-ticket items, but will increase their willingness to spend money on small-ticket fashion items, making shoes and accessories more attractive to consumers. We should also watch the theory of the connection between the length of skirts and economical development: recent fashion shows in Italy where skirts became considerably shorter again (don’t take this one too seriously).
Individual point of view
This list should make a good contribution to individual enterprises’ ability to look at their individual situations and come up with an individual outlook.
Regular readers know, that we have never been overly pessimistic, no matter how bad things looked in the recent past. The strength of consumption in emerging markets offset problems in the US. We warned frequently about the decline of the dollar and anyone who has taken protective measures (if needed) will have suffered limited damage. We did not expect the recent sharp fall, but the trend was set.
It might still be premature to talk about a turnaround, but it is at least possible to consider a turn for the better later this year.
Split splash
The split market is still completely dead. Tanners seem unable to find a fair valuation of this by-product and many consider themselves lucky to dispose of them at any price. Recent fashion trends and shoe shows did not deliver any indication of a change for the better.
The skin market is still delivering a better performance than the rest of the markets. Falling production of pigskins, especially in China, is making more tanners consider skins as an alternative. The start of the new season lamb production will show if a recovery in double-face production looks likely. Thanks to the strong performance of nappa skins, prices are at least cushioned.
The coming two weeks will see a lot of the trade travelling to Asia leading up to the APLF trade show in Hong Kong. We mentioned in our last market intelligence report that the traditional pattern would be to see the market peaking around the show and then start a moderate decent into spring and summer. Hide weights will get lighter in the northern hemisphere, which will have an effect on average returns.
If, and by how much, market levels could fade or if any of the above-mentioned pros will support prices into May will be seen after everyone has returned from the largest leather producing region in the world.
Without a collapse of the financial markets we see only a limited downward potential and it might be wise to take notice of the arguments which could reverse the raw material trend we have seen now for almost a year.
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