Macroeconomics

August is heading into its final week and the Olympics are now over. General activity in the financial markets continues to be influenced by the holidays as many people are still away from their desks.

However, the fact that people are on holiday does not mean that nothing has happened to influence the financial markets or that little happened. Our concern that the war in the Caucasus could become a factor unfortunately proved to be right. Although military activity has ceased, it is pretty obvious that the conflict was just a long-awaited opportunity for the Russians to have a go at regaining control of the only oil pipelines leading to the west that do not pass through Russian territory.

Knowing this, Georgia‘s activity as a potential NATO candidate is hard to understand and the Russians now feel comfortable about maintaining military control, not only of the two provinces in dispute, but of Georgian territory as well. They are not displaying any serious intention to leave Georgia. As a consequence, we are back to something that could be called the beginning of another cold war. The West is not seriously considering military action and we take comfort from the fact that Georgia is not yet a member of NATO.

The result has put a stop to declining oil prices, which came to a holt at around $110 a barrel. The US$ rose further and oil/US$ speculation continued its reverse trend until the financial world became rather concerned about the possible consequences of events in the Caucasus. This catapulted oil prices above $120 a barrel again and the US$ fell two cents against the euro once again. Last Friday, the situation calmed down as both the US$ and oil prices returned to levels seen at the beginning of last week.

The outlook for the global economy still remains rather gloomy and uncertain. While the Western economies and Japan continue to struggle and private consumption (retail) is not offering support, the emerging markets are still outperforming other markets. However, even these economies are starting to suffer because of high energy costs and a general rise in inflation.

Few pundits are very optimistic about the near future and it is only politicians that are trying to talk matters up, as they attempt to cultivate a positive attitude and prevent further decline. The biggest questions are whether the situation in China will change after the Olympics and whether general economical activity, which has been hindered by the Olympics, will to return to ‘normal’.

Market intelligence

Over the past two weeks, the focus has not really been on trading, but has been much more involved in discussions about how the rest of the year will proceed for the leather pipeline. In general, the trade is still pretty much saturated with pessimism.

The global outlook for general economic development does not look too good, particularly when it comes to private consumption and, with big profitability problems along the supply chain, concerns are far outweighing hopes. However, none of this is particularly new; we have been dealing with these problems since the spring. As far as we are concerned, we cannot see any major changes in the general environment and this means that the upholstery and car upholstery segments are dealing with a particularly grim outlook. We are not seeing any real change in the shoe business.

The crux of the problem is still the international financial crisis, which has been exacerbated by inflation and hampered by conflict in the Caucasus. Rapidly expanded production capacities in the first half of the decade are now facing a declining or steadying global economy. With demand shrinking most for upholstery the consequences are hardest in this field.

Movement in the beef sector

The situation is full of obstacles for producers and there have been sharp and major changes in the structure. It all started with the quick reorganisation in the beef sector. Further concentration has taken, or is taking, place all over the globe. Over the past three years we have seen large packers merging or buying into new markets and growing. The big deals were done last year, but more are anticipated. The recent announcement in France was that the number one and number two firms are creating another large conglomerate.

Furthermore, developments in the East should not be ignored or overlooked. The agro-industries in Russia and China are growing quickly and this includes a strong and intensive replenishment of cattle herds, including a modern beef industry. It might still take a few years, but the size of these businesses will become impressive and it will be interesting to see whether global demand for protein will grow quickly enough to absorb the rising output. Some of the exporting countries and large conglomerates will certainly face difficulties when it comes to placing all of their production on the export markets, which they have been thriving on in the past.

We are in a similar process when it comes to leather production. The environment is different but it has the same results. For shoe leather we are already seeing a little of what we should expect across the sector in the future. For example, let’s take the present market situation. A lot of people are still surprised about the weekly sales of US hides because they fit so little into the ‘market talk’. Let’s be realistic: we still have hundreds or maybe thousands of people in the ‘trade’.

However, the big markets are commanded by just a handful of large producers on either side, both buyers and sellers. They do not see any reason to share their business with anyone other than government organisations, which have a certain amount of power when it comes to obtaining information, particularly when it assists suppliers’ interests. We can see this at the moment as steady sales and regular shipments continue. However, the better the business is for tier one suppliers (packers) and tier one buyers (big tanneries), the more complicated it becomes for the rest. Less material is available for the free market and the chance to give product added value is pretty slight for any of the players.

More bad news for medium-sized enterprises

This situation is heightened by the market situation. The large global retail markets are increasingly dominated by a handful of large retailers and brand names that are plastering shopping malls and downtown areas with their shops, leaving less and less room for smaller retail organisations. This is even the case for the emerging markets. Although more distribution channels exist and the ‘open markets’ for the sale of fakes or unbranded products are pretty popular, new large shopping malls and outlet centres are being opened and, slowly but surely, this is paving the way for a rapid decline of ‘free retail’ business.

We have discussed this issue a number of times, but it seems appropriate to remind our regular readers about the situation, particularly for those that belong to the ‘endangered species’, the medium-sized traditional company within the pipeline. For those that are not niche producers, or suppliers of outstanding quality material, the market offers little mercy. With small margins, high leverage and a market structure changing, we have little hope for the near term. Indeed, we cannot see anything that could improve the business situation for the medium-sized companies in the foreseeable future.

Upholstery sector continues to struggle

If this is correct, it explains why the general sentiment is so much worse than the real situation. The sharp decline in demand for leather upholstery, problems in the Chinese tanning industry which has been further hampered by the Olympics, high energy and chemical prices, the structural crisis in Italy or, more accurately in Western Europe,  related to the strong euro are all genuine concerns. But the only really important factors are demand for the finished product and a shortfall in raw material production. The latter is a problem we are not facing, so the burden remains on the shoulders of demand. As a result, we are seeing flagging demand and prices for upholstery-related hides and almost steady conditions for hides related to the shoe industry.

We have been unable to see an end to this fundamental market situation for a while now and we are certainly not expecting change any time soon. The severe and deep-rooted problems for upholstery may be eased a bit when the upcoming production season begins, but the fundamentals for demand are not really improving. Tanners are not speculating about better times yet as it is more difficult to obtain credit and profitability remains low.

The upholstery pipeline is still overloaded and the problems have not all surfaced yet; clearance is needed before the situation can improve. It is worth mentioning the impressive stocks of raw material and the large number of containers of upholstery wet-blue and crust that have been stranded, mainly in Italian ports or in Asian ports for Italian customers. Chinese tanners have failed to honour contracts from the first quarter, when things were looking much better. There has not really been opportunity for sellers to replace material in the meantime.

Sentiments may improve

With the gap between the traditional side leather hides and upholstery hides now widening, the temptation for designers and producers to use cheaper options will be hard to resist. It might take a season, but the balance of a ‘fair average value’ between hide types will be achieved again. Without a sharp improvement in the upholstery or garment sector (unlikely in the short term), the value gap will most likely be narrowed by a moderate decline in shoe hides and a levelling out in the decline of upholstery hides. However, those making the calculations should also consider currency effects first, along with any local (tax and export/import restrictions) factors as well.

The coming weeks will offer more insight. The All China Leather Exhibition (ACLE) and the end of the holiday season for European tanners will provide a first impression, but nothing more. It is unlikely that there will be any particularly good news. Later in September and into October we will certainly get a better picture of the situation, because most orders for the high season production will be placed and, whatever the demand is, it will need to be covered by raw material purchases and production. Although the trade tends to overreact, the next weeks will be critical for the sentiments as we believe we are now entering the final lap of the downturn in sentiment.

Leather is competitive as a product again and this will be reflected in demand later. How demand will be restructured remains to be seen over the next two months. All this could quickly become obsolete if political conflicts become more critical. Since the beginning of the 21^st century, the world has increasingly been governed by political egos following ideologies that are less political and more related to power and money. Let’s just hope that this will not catapult us back to circumstances we experienced 50 years ago: overbearing political egos have never done the world any good. We are still dealing with conflict in the Middle East in the hope that this will not spiral out of control.

Skins sector is looking up

The splits market is still in summer agony. However, we are noticing more and more reports that splits are being used in no-name shoe productions again and that the consumption of collagen and gelatine is rising rather than falling. If we felt that this was becoming a firm trend, we would have a chance to put an end to the almost unrelenting depression in the sector.

Skins finally became a bit more active, in Europe at least. China has opened its borders for UK skins again, so skins from animals slaughtered after August 7 can now be imported. This has triggered higher sales into Turkey, where tanners decided to buy raw material before the Chinese start to absorb all of the good new season lambs again. Prices quickly rose 20% and producers even dared to stop selling, which we feel may be going a bit too far. However, everyone involved is interested in gauging Chinese appetite when they attend ACLE in Shanghai. The market could really benefit in the near future if good demand is confirmed.

We expect the time leading up to the show to be reasonably quiet. Many will travel in Asia, particularly in China, before ACLE in an attempt to get a better understanding of the post-Olympic market as well as trying to secure sales before everyone else tries to drum up business at the show. After the show, some further travel will take place, but hopefully by the next issue things will be starting to settle down and we will be able to offer a full and clear reading of the situation.

We should also know more about the situation in Europe. A lot of our sources are still expecting major problems with payments and people are already quietly admitting that a number of payments remain overdue from maturities in June and July. If the money does not come in after the holiday break, we could see further problems there. All this leads us to the conclusion that the turbulence is not over yet, and that we could see further trouble for the upholstery market before a potential end to the negative cycle in October. We will keep a very careful eye on the political situation. The US elections are coming up and the Caucasus could still deliver some surprises.

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