Macroeconomics

In the past two weeks, the focus has shifted from politics back to economics. The conflict in the Ukraine is far from over, but the financial markets have returned to their daily routine. It seems they do not believe the instability in the east of Europe will have any serious or long-term impact on global growth.

The financial community was far more impressed by the general good news from Europe, at least superficially. Greece was said to have made good progress and projected growth in Spain and Germany made most people believe that, almost six years after the financial collapse, the continent is delivering solid economic recovery.

However, there remain a number of warning voices and they are mainly disputing the data from Greece. Regardless, the country is returning to the financial markets and investors seem to be willing to borrow money again. You can see this from two perspectives: one, that there is confidence, but the other more pessimistic: that people are willing to take high risks for good yields.

The rest of the financial markets continue to be on a roller-coaster ride. Important commodities such as oil and industrial metals but also gold continue to trade up and down within a pretty narrow range.

Stock markets are doing pretty much the same, but they are in rather negative territory because they have gained much less than they have lost. So there is a split in opinion: people are willing to borrow money at reasonable rates to questionable debtors while walking away from corporate investments, which means they are not optimistic about the performance of private enterprises.
However, there is no one clear trend and it might take a little while before the financial markets take a clear position on their investments.

In the meantime, it seems the labour market in the US is improving and this is leading to more discussion the Federal Reserve’s money policy.

In Europe the situation is a bit different and despite the optimism about recovery there are some underlying fears about deflation. The stronger euro is reducing the import bill and many imported consumer products including energy are getting cheaper.

The situation in China continues to be vulnerable and it is difficult to get a clear picture. Businessmen and the people in the street are not painting a particularly rosy picture. The economy is stable, but not good enough to generate the growth the country has experienced for more than a decade. The massive clampdown the government is taking against corruption and to improve the environment are definitely the right steps for the long term, but for the moment this, in combination with the fragile capital markets, could lead to a pretty bumpy period in the short term.

There have been no major changes in the currency markets nor in the prices for the main commodities. They are all trading in narrow ranges and remain pretty much at the levels we have seen almost for two months.

Market intelligence

It has been more than a week since the Asia Pacific Leather Fair (APLF) in Hong Kong closed its doors and it is good to have a week to let everybody get home and to let the dust settle. It was, as expected, a pretty important event. Not because there was any particularly exciting news or market trends established, but because of the face-to-face meetings with all the people in the leather pipeline and it offered a lot of new information which is now waiting for interpretation in offices at home.

Whatever people conclude it seems that quite a bit of it is in conflict with what was discussed during the show. As we have seen for a while, everybody picks what suits them and if there is any consensus then it is that nobody wants to see raw material prices fall rapidly, because it would cause the majority of the players headaches and potentially big losses.

There was only a minority of visitors voicing concerns, and they were pretty soft in their positions. The vast majority were keen to talk of the stability of leather demand, which would lead to steady and regular demand for raw material over the summer and would justify the projection of at least steady raw material costs.

We prefer to deal with hard facts and so we will try to circle the news we obtained during the three days in Hong Kong and will leave it to our readers to draw their own conclusions.

The show had barely started when the Chinese leather association published its official statistics. It showed a decline of almost 24% in leather output in the year to March and made a number of people scratch their heads. How could the demand for raw material in the mainland be so strong, with everyone confirming rising sales, and at the same time output down? A lot of people discussed it but it did not negatively impact the mood. However, the number does need to be checked and analysed, because it is so far away from the business sentiment raw material shippers had.

We will monitor the situation, but the first thing to consider is that sheepskin production has been included in the totals. The sheep and lambskin business has been pretty bad due to the warm winter, although the problem in Hebei province, where the government has closed down the majority of tanneries, has not been reflected in the numbers, because that was too recent.

This leads us to another topic of discussion during the fair. The Chinese government has closed down almost the entire beamhouse capacity in Hebei province. Last week, a 20-minute report in the main Chinese broadcasting programme about pollution in Wuji shocked people. It displayed, however, how serious the Chinese government is about environmental issues, including in the leather industry.

So far only the wet end of the production has been affected. However, it is hitting that part pretty hard. The big industrial producers in the south and the east of the country are busy with shoe upper and automotive leather and have not been affected but a lot of leather production, which only shifted to Hebei in the past year due to cost issues, has now been stopped.

This is restricting the small and medium-sized producers that are manufacturing for the local market and this means mainly sheep and lamb, but also includes cow and other medium-priced raw materials. Global suppliers are trying to play the situation down, but it is obvious that shipments are beginning to congest, a number of letters of credit have not been opened, contracts need to be renegotiated and the industry is desperately searching for tanners outside the region.

This is not really affecting leather demand, but it is seriously hindering the regular product flow. It comes at the wrong time too, because we are now heading towards the low season in leather production and for the suppliers in the northern hemisphere, the spring and summer season begins which means warmer weather and less comfortable storage conditions.

As bad as the situation may sound it is impressive how little it appears to have impacted the market. Nobody was really panicked and prices hardly moved. If one can trust the information, many raw material suppliers were able to find solutions and price impacts have been limited. One was hearing of moderate price concessions which were hardly more than a couple of dollars on the original price booked. However, we believe this has to be seen a little bit more long term, because nobody has any interest in a collapsing raw material market and so buyers and sellers were trying to find quick solutions. Having said that, it is unclear if more hides are going to be waiting for shipment in the coming months and could pile up in sellers’ warehouses, with uncertain influences on the market.

A little less important are the customs problems in the south of China, but it is adding to concerns. China’s authorities have arrested a number of people in the Shenzen region for tax evasion and illegal importing, mainly through Hong Kong. This has stopped many shipments, but seems to have affected finished leathers more than raw material. However, some people have said warehouses are slowly filling up and shipments also being put on hold. The reaction in Hong Kong was quite soft with most being of the opinion that it is temporary and will return to normal in a reasonable period of time.

Regardless of the situation, leather will always be needed and produced and products with a market will be manufactured and sold. Therefore the sober reaction of the market is professional and appreciated. The panic over bad news in the past has been avoided and the situation is being managed professionally.

However, we have to be aware of the influence on leather manufacturing and costs. No matter when the leather production finds new capacities it seems that for the short term the cost of production is going to rise. The tanning costs in Hebei with cheap labour and little, if any, outlay for effluent treatment cannot be substituted at the same price. People have calculated a direct increase beamhouse cost of a minimum 20% and a cost rise including transportation and other soft costs could amount to 30%.

It doesn’t seem that the Chinese government is going to allow another production cluster polluting the environment at low cost. Retanning and finishing yes, but beamhouse operations will have a difficult time in China. So, production in China will be more expensive from now on and the time of the 'cheap production' seems to be over. This applies not only for tanning, but also for leather manufacturing – in particular for shoes. Even before this situation many large factories closed and shifted production to other destinations in South East Asia or the Middle East. China will remain a large, if not the largest, production centre of leather and goods produced from leather, but not just because of cost.

This trend was confirmed by production centres in other countries. Speaking to exhibitors and representatives from tanneries and shoe and leathergoods producers from Vietnam, Indonesia, Pakistan, Bangladesh and India (to name a few), we were told about strong rises in orders in the past month and, in the case of countries with sufficient domestic raw material, people were very happy about their orders because they were not as hard hit by the sharp rise of (imported) raw material. The bigger and better equipped units have gained the most.
We believe this is only the beginning of a trend and we could see much more manufacturing shifting or staying closer to the origin of the raw material, offering improved environmental controls and conditions.

For the moment it is important how the leather market is going to digest the rise of raw material and production cost in the next season.

The split market is still in the same gear as before. Wet blue splits remain in strong demand and it seems tanners have still not yet filled their needs. Lime splits are a different story, with prices for gelatine-related materials dropping. In China the situation in Hebei is again a problem, because for many tanners it was the market to buy blue or to sell their product. Now the tanning capacity is missing and the cost of production is rising, which has been answered by lower prices for lime splits. One cannot expect any change in the trend. The present prices for wet blue splits seem to be out of a fair valuation and a correction over the summer would be a surprise.

There are two aspects to the skin market. Top quality material suitable for nappa production and for the high end is still in good demand and prices are pretty stable. Double-face material is under pressure after the warm winter, made worse by the Ukraine crisis which is hitting one of the main markets (Russia). So, the present adjustment of prices cannot be considered a surprise. This is just a normalisation of prices which might be strange to some, but we are not concerned about the market as such. We will get a clearer picture once the new-season slaughter in Europe is in full swing and tanners have to put their cards on the table for the next season.

The nappa skin market is also being influenced by the problems in Hebei. It is the fellmongering centre of the world and for many suppliers – in particular from Europe – the main market is closed. This, in combination with the stocks in China and the rising temperature at origin and destination, is the worst case scenario for this market. Most big producers are arranging appropriate storage capacity while the others are trying to get rid of the product as quickly as possible. For the moment this means that prices are bouncing all over and one can see levels from 'on valuation' to pretty ambitious quotes.

For the coming weeks it seems the market is now in a phase of sorting itself out. What are the consequences of Hebei for the whole market? What are the leather orders for the coming months? Inventory? Split credit levels? In many ways the price structure of raw material is not in balance and several spreads cannot be justified. History tells us that this happens, but eventually values will return to normal ranges. We do not expect this to happen quickly, but the trends and direction will be set soon, depending on the decisions taken by those who are holding inventory.

We have the feeling that the price adjustment will lead to a general price correction and the market would be well advised to take a bit of pressure from the bubble to reduce risk and to take a break before thinking about the future of leather and prices in the last quarter of 2014.

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