The Leather Pipeline - 14.10.14
14/10/2014
The summer of 2014 was pretty quiet as far as financial news was concerned. One could feel there was something in the air, but nothing really happened. With the end of the holiday period the main focus was on political issues such as the crisis in the Ukraine and the rising aggressions of ISIS, with both of them beginning to have an influence on the international markets.
As September progressed, the more concerns rose until experts’ expectations for the global economy were revised almost daily and forecasts became more negative.
Over the past two weeks this trend has accelerated. In addition to the already existing conflicts, the umbrella revolution in Hong Kong made the headlines and hurt businesses in Hong Kong badly. Although demonstrators behaved reasonably well and the situation soon calmed down again, it is pretty obvious that the conflict can break out again any time soon again. Despite all the censorship, news is spreading to the mainland and the reaction to this of the Chinese government is something to be watched carefully.
Apart from the US almost all other regions around the globe are seeing a slowdown in their economies. All leading institutions are revising downward their expectations for global growth in 2015. One of the major indicators is the oil price, which continues to tumble; this is good news for the wallets of consumers ahead of the winter season. However, it is a worry for most of the central banks, because it is creating serious fears about deflation.
In Europe many were shocked by the decline of Germany’s industrial production in August as well as a serious reduction in monthly exports, because many were of the opinion that this strong locomotive, which dragged the rest of the region out of recession eventually, would never slow down. This is bad news when we realise that most of the other countries in Europe in crisis such as Italy and France have not made any serious progress with reforms or taken any turn for the better. With all the problems in the slowing global economy this is pretty bad news for the recovery in Europe.
The Federal Reserve is not showing any rush to raise interest rates and decisions about the end of the quantitative easing policy are being delayed again. Before its announcement, the euro crashed with investors expecting that interest rates in the US would be lifted soon in view of a better labour market and reasonable growth. The opposite applies for Europe and many investors pulled out of the euro, which fell down to almost $1.25 before seeing a rebound towards $1.28 before sliding moderately again. However, expectations for the EU currency remain negative.
Stock markets and oil prices fell as well and oil is hitting lows almost every day; this is in line with the general change of the mood regarding the global economy.
Market Intelligence
The fog that has hung over the leather pipeline for so long is beginning to lift and the outlines are becoming clearer. As usual the market needed a trigger from outside. This time we have had numerous political problems and a decline in many commodity prices.
For a long time now we and other pundits have been wondering if the present price levels for raw material in the bovine sector would have a negative impact on leather demand. Raw material suppliers, in particular in the beef industry, have stubbornly insisted on restricting supply and this, combined with global rising purchasing power, could only mean rising price levels for hides. On the other hand, we have manufacturers of consumer products looking at alternative materials and possibly reading consumer demand in a different way.
In the long run global population and purchasing power may indeed rise. But to come to the conclusion that this will mean a linear increase in demand for products made from leather has always been the wrong perspective. Everything had been totally overwhelmed by the massive expansion in the production of automotive leather and the fantastic time the luxury industry has had in recent years. However, it cannot be said frequently enough that there is no need to use leather in all applications and we must be prepared for changes.
These changes and declines in demand can come from many different directions. The general slowdown in the economy, fashion, price, image or if you like just something like a bit of fatigue in consumer interest for certain products. It can also be psychological, something negatively influenced by a general feeling consumers get when watching the evening news on television.
Another serious evil is the general management philosophy that has come into force that bad news or a cautious outlook must never be displayed if competitors are not doing the same, so that everyone can blame general circumstances.
Anyway, with the general change in expectations for the global economy as a result of the numerous political problems, the effects have now reached the leather business too. There is nothing really new, but before businesses these days admit anything, it has to be happening already. The problems between the West and Russia, with sanctions imposed, the dangerous conflict in the Middle East, the slowdown in several emerging markets, like for example Brazil and Turkey, the change of the general political climate in China and even the ‘umbrella revolution’ in Hong Kong have had a pretty negative impact on the general consumer business in many regions.
We believe we can say that the biggest influence on the slowdown of demand was not the political situation but the price levels that raw material and leather reached at the end of last season. And if it was not the price it was the continuous message that the prices reached were a consequence of a shortage of raw materials. As a matter of fact, that has never been true but if you tell your customer that he has to expect rising prices as a consequence of shortages in supply, what do you expect him to do? Many began checking for alternatives and, unsurprisingly, they found a number of options.
Check what materials have gone into the shoes that have arrived in the shops for this autumn and winter season. It might even be enough to check websites to see that leather has been eliminated from much of mass production. Many will remember that split prices were shooting up between the end of 2013 and this spring before they almost collapsed. We have seen a similar pattern with lining types of sheep and lambskins for use in winter boots. If you look at the shoes that have been made in the past three-to-six months and arrived on the shelves in September, you will realise that a lot of split has become man-made materials and linings are, in many cases, either woven lining materials using natural wool or microfibre.
When the trade returned from the summer holidays and gathered in Shanghai and later in Milan the flurry of the typical after-holiday activity was camouflaging the real situation. The volume of leather business is presently a good proportion lower than it was a year ago. This version of Market Intelligence is not intended to predict Armageddon for the leather pipeline, but to make people aware that it might not be too wise to ignore the hard facts for too long.
The main problem is how to deal with the situation. Nobody has any interest in a sharp and extended correction in raw material prices. This might be needed, but the industry is scared of the consequences. There is still some stable business, as there always is, however, we all know how difficult the discussion with tanners can become when they smell that raw material prices are weakening and there might be room for serious discussions about prices or even renegotiation of existing contracts.
Many businesses are concerned about their inventory valuations. Numerous businesses are closing their books for the fiscal year at the end of the calendar year. A major correction in market prices could mean that stock valuations will be needed to be adjusted to lower market values. In a year that has already not been too easy for many as far as margins are concerned this could be a serious and even dangerous influence on company results for the year 2014.
So how to get out of this? On the one hand, it is pretty obvious that raw material and leather prices have to find a new, lower and more attractive level to stimulate demand again for the next seasons. Leather has to become more competitive again. For the current season we would say that not much can be changed; it is unlikely that leather buyers are willing to increase existing orders in response to a jump in consumer sales in September and October.
Basically we feel that we have run into something like a dead end and the main complication is that we have not used the summer and holiday period to let prices slide. The beef industry had been very rigid in protecting the value of its by-product; there are very specific reasons for this, which we may deal with in one of the next issues. For now, we need only mention that it is directly linked to the strategy of adding value.
There is no question that the absolute premium end of luxury product manufacturers are still enjoying a pretty good performance. However, one should really watch and analyse how much leather the top 20 brands are really using. They are not the ones consuming all the expensive veal skins and leathers. It is all the others who are trying to hop onto the same train and become a brand eventually. These are the companies that generate the volume and they are the ones who are pushing demand. In the good times they grow fast, but they are not able to offer the margins and the stability in business that the top end can. When sales are not performing and profits are not longer good enough for the investors, they are the first ones to try to expand their margins by using less expensive materials and this can be anything from cheaper leather to synthetics. One consequence at the moment is that calfskin prices are dropping across the board now, with the non-absolute top qualities already down by 20% to 25%.
We might also have to watch the automotive business. For the year 2014 we are quite sure that productions will remain high and none of automotive brands is going to cut production judging by the sales forecasts they have made. For the year 2015, however, the premium brands might have a bit of a rougher time than many thought. Yes, as a result of the fantastic performances of the past couple of years many new models are rolling out, production budgets are running high and, so far, no correction has been made to this. But looking at the global economy, realising the problems in many markets and noticing in particular changing policies and the treatment of premium manufacturers in China, one could be tempted to put a question mark against all the positive expectations that have been published about the business for next year.
We are of the opinion that the long cycle of rising prices has run out of steam. Slowly but surely the balance between supply and demand has shifted and, from market segment to market segment, a surplus of raw material has begun to build up because of under-performing leather demand. This may still be covered by the overcapacity in tanning that we still face around the globe and some of the surplus has been or is still hidden in inventories. But we also have a number of raw material markets that are suffering from the difficulty to place all the material produced. As long as sellers, in particular from the beef industry, remain optimistic about a quick recovery of demand, and as long as their financial resources and warehouse capacities allow them, they might be able to withstand the strong headwinds and maybe this will be for the best for everybody.
It remains to be seen if the strong players in the beef industry are able to manage not just shortage, but also surplus periods. Tanners worrying about supply are beginning to feel more relaxed and are more willing to buy hand-to-mouth than before. The major worry we have in this case is the big spread between origins and different materials we have today in the market. From our perspective the spreads is too wide and could be closed quickly with an increase on the lower side of the price range. Currency plays a major role too and we have seen over the past weeks how much the currency markets can actually change the price structure.
The split market remains vulnerable. At the beginning of September we could trace some indications of a recovery. However in the meantime this has faded and the split market is just steady at best. In particular in China the market for lime splits remains under pressure due to the lack of tanning capacity as a result of the strict effluent controls of the government. The problems with lime splits in China would be less interesting and just be a local issue if one could see a better time for splits in other regions. However, except for some specialities there are few signs of better demand.
The skin market continues to suffer from a lack of demand for standard nappa and double-face leathers. The sharp devaluation of the Russian currency is making exports to Russia extremely difficult. This is hitting exports from Turkey and also from China very hard. A relatively warm autumn so far has also delayed consumption of warm leather jackets for the winter season, which means cash-flow problems may not be far away. The Muslim Eid al-Adha festival has boosted supply in the past weeks and so business remains pretty difficult. Only a few players with strong financial resources are taking the chance to build up some stock at very low raw material price levels. The market is just a bit better for some high-quality specialities, which have to be bought seasonally. Standard-quality products of sheep, lamb and goat are not very far from the historical lows seen after the crisis in 2008.
In the coming two weeks the supply side has to decide how it is going to deal with the present situation. There is enough raw material around and suppliers will have to decide what they are going to do with it: continue to keep asking prices at or around the levels we are now experiencing or be ready and willing to adjust prices to levels that are a decent proportion lower. For us it is more a question of how and when, rather than if, this is going to happen. If we want to prevent more damage to leather demand it is time for price adjustments.
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