MARKET INTELLIGENCE – 02.01.08

Macroeconomics

Welcome to 2008 and a very happy, healthy and prosperous New Year to all our readers!

We will take the opportunity of this first issue of 2008 for a more general outlook into the New Year and deal less with the short-term issues from the financial and political scene, although a few notes about the end of 2007 are probably still needed.

The assassination of Benazir Bhutto at the end of December gave the Western world another demonstration of how unpredictable and uncontrollable the situation in the Middle East and Asia still remains. Western policy in this area has clearly failed and the circumstances of the murder will hopefully be clarified in the end. At the end of the day, whoever was behind the murder was only interested in destabilising the country and the region and the world should be aware that extremists are, step by step, getting closer to possessing nuclear weapons which might be the real reason behind these latest actions. One thing can definitely be concluded at the end of 2007—the world hasn't become any safer. It still seems that many countries in the world—or maybe better put, their leaders—see the potential threat but many, and particularly in the emerging markets, are much more focused on economic growth than global security.

US$ continues to weigh heavily

For those not living in the US dollar world at least, the situation of the American currency is also of quite significant importance. After almost two weeks of gains the US$ lost all the advances it had made in just two trading days and this was another good example of how vulnerable the US dollar remains. We would not dare to make any predictions in this area and just how insecure the analysts are feeling can be clearly seen in the large spread between their forecasts for the future of the American currency. While many think that the worst has already been seen, almost the same number consider that the steep fall is not yet ended. One lesson that must have been learnt in the last month is that if one has to sell dollars it might be wise in the short-term to take your chances on the day as there are no signs of a significant turnaround for the greenback as yet. 

However, although most predictions are still very positive about the economy in the euro zone and quite sceptical about the future of the US economy, a few question marks still hang over this statement. We, at least, believe that for the foreseeable future, decisions concerning the currency markets will more likely be made in Asia and maybe in the Middle East rather than in the old financial centres such as New York and London. So, it might be best to check a little more carefully what is decided in Singapore, Hong Kong, Beijing or maybe even Dubai in 2008.

Belts tighten further

Another issue of great importance is energy prices and, of course, also food.  All the discussions about inflation can only feed our concerns about the potential influence the rising prices of the basics of life could eventually have. In the USA, and also in Europe, many families are already overstretched and the rise in prices for food and energy is making the situation even more difficult. If food and energy prices rise further less money will be available for many families to pay their mortgages or the monthly repayments on their so ‘desperately needed’ consumer products such as cars, TVs or computers.

Olympic cuts?

Another subject which could become important for the leather pipeline is the Olympics in China in August 2008. In order to make a good impression on the world during the Games pollution will be a very important issue. So one wouldn't be surprised if the Chinese government calls to cut energy supplies to non-core industries which not only cause a high level of pollution, but also consume a great deal of energy. The leather industry could definitely be seen as one of these. Even maybe just because it is a small industry, power cuts or governmental instructions to shutdown production for a while would really come as no surprise.

So whatever happens in the political arena or the financial markets even minor questions such as if the Games in China will have an impact on the leather pipeline all lead us to believe that 2008 is not going to become an easy, quiet and peaceful one. We strongly believe that the market volatilities will increase and this is going to be bad for businesses and investors alike as it will present a great challenge for them to steer around the obstacles and make the right short-term decisions.

In general one can expect wealth to spread more and more into the developing world, but it will again be unevenly distributed among people, but the fundamental stable or rising demand for consumer products will also be sustained in 2008.

Market intelligence

Before we start with a general outlook for 2008, we would like to quickly review the last weeks of 2007.  We have already been observing for quite some time that some of the reports from the United States are more pessimistic than the market realities actually confirm. This was also the case for the last month of 2007.  Despite continued expectations that the market would fall further, prices remained reasonably steady and looking at the export sales and shipments there was no real sign of any major downward corrections.

In Europe the situation is completely different and we have already dealt with this subject in the last two issues of 2007. Despite the rising US dollar up to Christmas, very little support was seen for the European markets and this was certainly mainly related to the long break in the European industry around the end of the year.  Many factories shut down for two to three weeks which cuts the demand for raw material by much more then the cut in production for beef, or better put, hides. In particular those grades which do not traditionally perform in overseas export markets have had difficulties in finding sufficient homes and this kept the pressure on the market well into the end of the year.

Having now seen a falling market in Europe for almost eight months, it is also now a question of a lack of confidence and—as we all know—this trend feeds itself after a certain time.

Shifting concerns

What we saw in 2007 was a shift from concerns about raw material shortages to feed overcapacity in the tanning industry, which had been built upon good profits in 2005/2006, derived from strong demand for leather goods, low production and energy costs and low raw material prices. In the first quarter 2007 many raw material markets peaked in price and with rising production costs, stricter pollution controls, a falling US$ value for the Europeans and restrictive tax policies in China, margins eroded quickly and profitability moved into the foreground of business decisions. The first area to give is always raw materials with all other parameters hardly needing to change. With retailers and consumers unwilling to spend more money on leather goods or to appreciate the material as such, raw material prices were guided lower despite consistent demand. This formed a bear market but without unusual stocks. This pushed us to argue that the situation was less a bear market than a normal economic correction.

At the same time buyers had to be happy that (most) sellers realised the situation and were willing to follow the situation and consider their position before prices and decided with their main customers and buyers to guarantee product flow if the supplier was willing to accept adjusted price levels in the second half of the year.

Two-tier trading

This had created a two-tier market which has also led to wide discrepancies between opinions about the market situation. While key suppliers and customers were quite content with the situation, as one was securing shipments and cash-flow while the other was happy to have guaranteed supplies of standard raw materials at falling prices to steer their business back into better margins; for the second level, the situation became more problematic—and in our opinion this has caused the many negative stories and opinions which are circulating the market—because a lot of the tier two tanners around the globe closed or reduced their business due to their individual circumstances (currency, pollution, tax, cost etc.) which left many of them with little or no business. The consequences are always the same: either the inventories of these second tier businesses quickly rise or they have to take such discounted prices that business turns sour for the time being and they struggle to find any good news to report, which might have created some of the negative sentiment which has been circulating the trade for some time now.

Since 2007 has ended and 2008 has already opened its doors, it is time to look into the fundamentals for the year ahead.

Looking long-term

Although most producers would claim that they still require further declines in raw material prices and with the recent trend feel even more comfortable in expecting the same, it could be wise to think a little more towards the long-term and question where the average price for the coming year or production season could be. We don’t fancy the calendar year so much, because it doesn’t actually really reflect the average price calculations for leather makers. We prefer to evaluate the period from July 1 to June 30 which, in our view, reflects the situation much better for the leather pipeline in terms of production rather than the calendar year.

If one looks at this time frame since 2005, the situation presents itself a little differently and one can easily determine that the 2006/2007 season was a problem. Prices moved up in most markets until they were out of range by the start of October 2006 with a peak in spring 2007 and the final correction over the summer of 2007 into the last quarter. The 2005/2006 season had, in contrast, been almost perfect. Looking at most prices today for the 2007/2008 season we are just within the normal long-term averages and some markets which are exporting in US$ and are disposing of economical material are still well above average.

Now some may argue that this view does not consider the increased cost levels and that this should justify more correction to compensate. This might be true, but it disregards the fact that the supply situation of hides is not unlimited and, in our evaluation, the demand for leather products still remains in pretty good shape.

Lack of balance

What we are indeed considering is the fact that the demand structure is not balanced and this might still need to be sorted out. As we have already seen in 2007, cheaper quality materials such as lamb, sheep and goats became more attractive substitutes—wherever they can—for more expensive bovine materials such as calf or kips. We have also seen that leather in mass production upholstery is losing ground versus synthetic materials in order to meet the price targets of retailers and this leaves more raw materials available for the production of shoes and leathergoods. Also the situation on the split market is still not resolved and without a change in fashion or a rise in leather prices this material base is not adequately represented at present.

So, the situation for leather producers will not be easy, but it might not be as bleak as they think it looks today. Raw material prices have declined but when, at the same time, we are complaining about the rising cost of energy (oil) we also have to say that price for leather alternatives is rising too (and by a lot). As many of the materials used in these alternatives are also oil-related, they too are seeing their prices rise albeit with a delay, but in 2008 the next move will come and this will make leather more competitive again in some fields.

Steady demand

Despite the concerns we have about the volatility of 2008, the demand for leather will most likely remain intact which is also good news. The shooting stars of the last two years, i.e. the BRIC (Brazil, Russia, India and China) nations, have been quoted many times already, but the growth rates in other countries are impressive too, just look at the Middle and South America and even on the African continent, where although there still remains much disaster, more nations are starting to wake up and to perform better.

Falling barriers?

Apart from the political problems another big issue for the hide, skin, and leather industry is trade barriers. Not only the old ones we all know from the past such as raw materials which are not allowed to be exported or export taxes preventing the same, but also the indirect ones which are often not considered, such as import licence policies, veterinarian issues or the simple inefficiencies of customs offices which hinder the free flow of material. This does not even include import barriers or price dumping strategies.

Some countries such as Russia may soon even determine that their policies of the past could be their problems of the future when new factories are suddenly unable to dispose of enough raw material, as they fall over the very fences that had been set up to protect them from raw material exports in the past and which could now hinder them from having access to adequate raw material. Suddenly they are finding that insufficient local (subsidised) raw material is available to meet domestic and export demand for their products and nobody has paid enough attention to preparing officials for foreign (legal) imports to possibly compensate for this. Russia could become another good example of how government policies of subsidised and protected industries could become another strong player in the international raw material markets in the future.

With the balance of demand and supply as it stands at present and with the outlook we have for 2008, we still do not consider it to be a good bet to expect raw material prices to sort out the profitability problems of many as yet.

Individual issues

Let’s now take less of a general perspective and more of an individual one. One should also take a close look at transportation and transportation costs. There is a significant difference today between the time, cost and equipment available which could support and harm buyers, sellers and producers in the future. Here and there logistics issues have already become a major concern as equipment is either limited, it has become overly expensive to transport raw materials, or just the different geographical locations of two destinations can already make a big difference for the people involved.

A comeback for splits?

There is not much to report about the other markets. Skins are performing better because of a reduced kill in China and rising demand for skins, not to forget wool in the case of sheep and lambs. The outlook for 2008 is also not negative. Skin prices have not been inflated and therefore price has not crated a barrier for producers.

Everything that can be said about splits has already been said and we would not be surprised if 2008 were not the year of the comeback for splits in leather production. This would also be relevant in terms of supply as it would keep supply issues under further control.

Well, there’s a lot to think and worry about and—as usual—many things will be different than one plans or wishes, but we hope we have been able to trigger some thoughts.

We would again like to wish our readers a very happy, healthy and successful New Year!

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