Market Intelligence—18.11.08
18/11/2008
Macroeconomics
Nothing has changed in the past two weeks—at least not for the better. The financial markets have really had little chance to rest. The global system is still in deep trouble and all the efforts of governments to stem the malaise has protected against an immediate implosion, but not really helped much to prevent against a dramatic economic downturn.
A large number of countries are trying to introduce intensive stimulus programmes and some are throwing big numbers into the ring. Even China can feel the pain and after the slowdown in exports domestic consumption has suddenly suffered too. So a $500 billion investment programme has been announced by the government, which sounds a lot, but because of the sheer size of the country and economy it will not change much.
Exaggerated importance
Once again, the biggest problem in our opinion is the media and the general public relations surrounding the situation. It is the usual story of exaggeration; people talked things up too much until around the middle of this year, and now we have the reverse trend. Analysts are falling over each other to forecast a global depression for 2009 and public statistics are confirming a statistical recession in many countries already.
Nobody knows what is going to happen, but when there is growth of 1%, the world is in order, but when there is 1% negative growth—the same number—economists everywhere seem to need psychological assistance. With the speed of information today, the ‘me too’ effect kicks in quickly; that applied when businesses expanded, and applies now as well the contraction of business and cuts in production. The biggest threat is rising unemployment. This is cutting spending ability and is also the biggest threat to consumer confidence.
The consumer confidence question
The volatility of the currency and stock markets remains very high. Daily movements remain pretty high and clear direction is still missing. Commodity prices are still falling and the consumption has now finally been hit in the emerging market. In particular in India and China consumers are cutting consumption sharply.
The good news is that with raw material prices falling sharply and oil prices also remaining on a downward track, many business are finding relief in their cash-flow needs, and margins are widening. Consumers can hope for a substantially lower energy bill for the coming months, which is also going to ease a bit of the pain. So the fundamentals are much improved, and all that is needed is for consumer confidence to revive to allow businesses to take advantage of the situation.
This may be a difficult job with most of the world being talked into depression and it will be difficult to convince consumers to spend when at the same time news bulletins tell them their future looks pretty grim, they must tighten their belts and their jobs are not safe.
In any case, as of today we would still describe the mood as being much worse than the actual situation.
Market Intelligence
We think, that the last two weeks have probably been the most painful in history. We were prepared for a sharp correction in particular in the markets dealing in US dollars. We talked in our last issue about the overvalued US prices and the need for them to be corrected by between 10% and 15% to get in line with the international levels.
But things got worse. As the days went by in the last two weeks, the more sellers realised that they were defending a lost position and realised that, in the end, no matter how much you panic, you cannot hold back an avalanche. Prices in particular for cows of all kinds started to slide, with the momentum of this slide picking up in the last couple of days. In sympathy, some other origins have also begun to suffer and prices have been bouncing all over the place with nobody really actually knowing any more where the real market is. Price spreads of easily more than 10% for the same product became pretty common during last week.
So what has happened? The market has become the victim of an explosive cocktail that has been building up for a while. The never-ending bad news about the global economy, the unbalanced price reductions in a number of markets, currency movements and the financial crisis have combined to produce such a lack of confidence that buyers have all but gone on strike and sellers started to panic.
In particular prices for medium and low-end material came under massive pressure and although it is very difficult to find ‘the market’, price reductions of 20% were easily seen. For some markets, like the US, we would consider this just as a correction, an adjustment to what has happened already in other markets. But it has triggered an additional downward price spiral and did not leave other origins untouched. It was the final shot of courage in the arm for hide buyers.
Buyers can take it easy for the time being. Hides in the medium-to-lower end continue to pile up and in some origins, such as South America, it is already becoming pretty common for processors or wet blue plants not to buy hides any more, but for these just to go for contract processing or to remain the property of the slaughterhouses.
With the usual slowdown of production toward the end of the calendar year and the reduced shipments to Asia in December owing to the Chinese New Year festival at the end of January, there is no rush for buyers to secure raw materials, as low and attractive as hide price may seem right now. We are also dealing with the usual psychological factor one has to deal with in a falling market. Everybody feels that what he has bought or owns in raw materials is too expensive and it is better to wait for better options.
Well, this scenario applies only for those tanners who are not able to plan their business with existing leather orders. And this is the biggest problem today. Nobody actually knows what the demand for leather is going to be. The entire pipeline for standard consumer products is almost paralyzed. The credit crisis has in the meantime either had a very negative impact on the economy of some emerging markets (such as India) or has dampened confidence (China), and consumption has begun to suffer in these markets too. We are now ahead of the two largest shopping seasons, Christmas in the West and New Year in China. The retail industry wants first to see what consumer reaction is before taking any decisions about reordering or stocking up for the next seasons.
This has led to a complete ‘wait-and-see’ attitude, which is slowing down or even stopping at the moment the flow along the manufacturing pipeline. With no confidence and commitment from retail level, no manufacturer can plan production and commit on raw materials. Everybody knows, that we are not at the end of civilisation and consumers will continue to spend, but they will spend less for a while and production capacities, which had been built up in recent years in expectation that there would be budget for never-ending growth, will fall.
This leads us to one of the problems that are the causes of many of the present difficulties we are facing. It is not only the speculators and irresponsible players in the financial markets that have caused a lot of trouble, but also a lot of the so-called modern styles of management and the expectations of stock markets and analysts. Investors and banks have taken over the world of business and they expect everything to be forecast, planned and budgeted. Producing quarterly results and the next balance sheet have become the only target of running an enterprise.
Flexible, breathing, sensible forward looking and anti-cyclical management decisions were entirely out of fashion in the opinion of these experts, and running businesses on short-term results (driven by bonuses) as well as the ‘me-too’ mentality of employed company leaders, has resulted in a global growth scenario that has not been anywhere close to the real market situation, with inflated production capacities and raw material demand that was too great for the actual market size. Today managers are blaming the credit crisis for their failures, but in most cases this is just an easy excuse for their own mistakes, and for the defects of the system that has not allowed companies to be realistic and has not permitted cautious and anti-cyclical decisions.
Homemade problems
Already early this year buyers’ resistance for certain model types was easy to see, but instead of taking decisions early in the budgetary year and making provision for being able to correct plans and decisions, hope and wishful thinking dominated—people did not want to spoil the summer holidays. In the end, the financial market crisis came as a suitable excuse for many homemade problems that were already present.
Other sectors in the leather industry suffer from a similar problem, but with different parameters. In the shoe and furniture industry businesses are not really global; the landscape is much more fragmented. So, the individual size of the companies can never have a full global effect and they do not have anything similar to market research or quick market feedback. However, the leather industry as a whole has probably also been caught up in all the great expectations and prospects. Probably not so much by the demand and business in the established markets—because their demand and potential is pretty well known—but more by the uncontrolled growth in the emerging markets where the fascinating business outlook seems to have encouraged too many to build or to expand their factories for an unknown market size.
This has led—in particular for upholstery—to a significant overcapacity of production, which became apparent earlier this year when growth started to slow down and the big problems of increased production cost and high raw material prices were already putting an end to the ‘anything goes’ philosophy in the markets.
Chaos theory
Having tried to offer some explanation of the present situation, we should probably say a bit about why we have entered in such chaos; this may seem like something of an exaggeration, but it is a fact for the time being. The financial crisis has added to market problems by limiting business volumes and access to capital and finance. Another factor is that adequate credit insurance is no longer available for many customer relations—or, even worse, some potential producing nations.
The leather industry in Pakistan is already feeling the pain because suppliers from overseas cannot negotiate letters of credit any more with the financial system in the country looking pretty vulnerable. Iceland being already almost broke (not really a worry for the wider leather industry), but other nations could also quickly run into the similar troubles and although the situation is different today we should not forget the year 1997–1998 and the crisis that was triggered by the financial problems in South East Asia, followed by Russia.
Immediate future
Where does all this leave us for immediate future of the leather pipeline? Well, for 2008 it seems there is very little left to rescue. There are only six weeks to go, not counting holidays for Christmas. With the lack of orders, many tanneries in the western world will most likely send their workforce home for an extended break. In Asia in January, production will ebb owing to the Lunar New Year holiday.
Many businesses have present problems to deal with and are desperately trying to generate new business or new orders, which is not easy in the present environment. As if that were not enough, many have also to handle their accounts which could look pretty ugly due to devaluation of stocks, or losses due to burdening overheads or the renegotation of losses from old contracts.
Favourable parameters for leather
So, for the near future cleaning up will be in the foreground of the activities of the leather pipeline. Those who survive this process will have a solid base to think about their future. The fundamental parameters of the production of leather and leather products are going to be favourable. Low raw material prices, reduced cash needs and falling production costs are always solid ground for leather products. Leather as a product has the chance to return not only to be a product of quality, but also a material which is competitive in mass production.
However, this process could take some time. In the past six months leather production has contracted much more than the supply of raw material. This has built a significant inventory of material along the pipeline, especially in medium and lower end raw materials. A hit on the luxury market may still come, but so far the demand for medium-to-higher end products has not been influenced that much yet. However, this market is only a fraction of the total.
Market cuts
We consider today, that non-shoe production accounts for about 35%–40 % of global leather production. This market could, in itself, have fallen by around 30 % compared to a year ago. Additionally, we consider the shoe business to be about 10 % less than a year ago, which gives us a total reduction of about 15%–20 % for the whole leather market. This does not take any timing matters or inventory variations into account.
Reasons for rises
When we review the split market, which had taken no benefit from the firm hide market until spring this year, we have to believe that there was never any shortage of raw material, normally the driving force behind the rise of hide prices. It was much more a combination of increased capacity (not demand), access to cheap money and a general enthusiasm for commodities on both sides—sellers and buyers—which allowed prices to rise. As a consequence, inventory has been rising quickly in the last months when supply remained steady, but demand, in particular for upholstery hides, faded quickly.
As we have discussed before, there is little chance that any substantial reduction of inventory can occur in the coming weeks; quite the reverse, stocks will most likely tend to rise still until early 2009. To absorb these inventories it will need a certain period of time with better demand to clean up what is building at the moment. Again this applies in particular to the medium-to-lower end, which is where the real volume is, both for production and supply.
So, for the short term most parameters still look pretty negative and for a real and fundamental change we would not only need restored consumer confidence, but also leather penetrating more consumer products again.
The next breaking point will be mid-January. Asian buyers have not actually made much planning for the time after their holiday break and we must not forget that a big proportion of expensive contracts have been cancelled and will not now be shipped. These numbers can today be considered sellers’ stock and not buyers’.
This is also part of the equation and also already taken into account in the market price levels. However, to keep production running and to produce the leather that is still needed, tanneries will have to start buying hides again. Before the holidays, buyers will have to take a decision about their needs from February onwards and they are going to be quite regular. To absorb the existing stocks of inventories we would need a rise in business or buyers’ speculation, so that the stocks which had been pressed backwards in the pipeline can move forward again.
The chances for later in 2009 are not so bad. Money will become cheaper and margins in leather production will improve, which will restore confidence. Strong hands know already that they have the chance now to secure long-term stability in their calculation. Prices for raw material will fall further to levels that could also affect supply. Ultra-cheap material is no longer worthwhile saving or processing. As soon as the market settles, we will experience flurries of purchases and a shift of inventories back into manufacturers’ hands.
Little chance for splits
The split market for leather production has little chance these days. With the price for hides where it is today, only specialty products can still justify the use of splits.
We would say, that there is no real market for splits for the leather production that remains these days. The trend for lime splits for gelatine and collagen production remains in reverse. Falling production has actually led to a decent shortage of material and producers of gelatine and collagen products are unable to get the supply they bought due to the massive production cuts in the tanning industry. This is obviously leading to rising prices.
The skin market is also starting to suffer. The price of wool has been falling and the sharp decline in bovine material is now also pressing hard on lamb and sheep skin prices. Further restrictions on the industry in China are also weighing on the business. It has come to China later, but it will be just as hard. The only consolation is that prices for ovine material have not been rising that sharply, so that a big crash like the one 10 years ago will not happen. However, there will be harsh headwinds in this business also.
For the coming weeks one can only remain pessimistic. Things have not yet been sorted out and we can only hope that the developing panic seen in the last week will not end in a complete collapse. Further contracts not honoured, documents not paid, credit covers cancelled, bankruptcies and so on could result in a pretty serious situation.
The industry would eventually be definitely paralyzed. This would be neither needed nor justified. We are still not so pessimistic that we see any need for a drama. Footwear demand remains pretty solid. Accessories will also see a recovery soon. Small ticket items are selling better in a crisis and leather accessories are very competitive in the world of gadgets today.
For upholstery and automotive the road will certainly still be difficult for a while, but we should see later in 2009 an increased penetration of leather in smaller cars. If automotive manufacturers become a bit more flexible in the crisis, why not? There is certainly no need to rush, but we still believe that controlled replenishment of inventory will be the best policy of all if one wants to be part of the industry also in the years to come.
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