Credit Suisse says markets face threat of vanishing liquidity

The Australian sat down with top Credit Suisse advisers to discuss the global investment landscape.

Andrew Main (Investments editor, The Australian): We’re going to start global and go local as we move along. The first question is to Robert Parker: how do you see 2015 in the global market? Where are the big risks?

Robert Parker (senior adviser, investment, strategy and research group, Credit Suisse) : I think the big risks are monetary. If we look, for example, at the US Federal Reserve, they’ve increased their balance sheet to $US4.4 trillion from $US800 billion at the time of Lehmann Brothers going bust nearly seven years ago.

Andrew Main: They ran the printer pretty hard.

Robert Parker: They’ve injected $US3.6 trillion ($4.7 trillion) into the US dollar money market. So, risk number one, actually, I don’t think is whether the Federal Reserve raises interest rates or not; the risk is: do they start to shrink their balance sheet and take liquidity out of the system?

The correlated risk is, the European Central Bank has said very clearly they’re going to increase their balance sheet from €2 trillion to €3 trillion ($4.3 trillion) by September 2016.

What happens if later this year Mario Draghi makes a speech saying, actually the eurozone economy is doing very well and by the way it is starting to accelerate and therefore we don’t need to do more quantitative easing?

So I think that liquidity issue is absolutely critical and there is a very clear correlation between the extent of global liquidity, which of course at the moment is abundant, and global markets.

And if you start to take liquidity off the table, that actually sends a very negative signal to global equity markets and, for that matter, global credit markets.

Andrew Main: In the meantime we’ve got markets where already asset values have been pushed pretty hard and there’s a scramble for yield.

David Murray (senior adviser, Credit Suisse) : It adds to this risk people are concerned about in the equities markets, but when you look at the decisions people are making, they’re entirely rational given the monetary policy settings that we’ve just talked about. So the issue is whether they have, depending upon their investment circumstances, the capacity to remain patient enough to see through any adjustments in the equity market.

The real issue is where pension funds, in particular, go for fixed interest returns. As you know, a rational investor, once again in the current environment, might keep shorter than they would traditionally, particularly when they look at the potential outlook for sovereign bonds around the world.

David McDonald (chief investment strategist, Credit Suisse private banking) : What’s happened is government bonds globally are just not attractive. The problem locally is there’s not a lot out there beyond the government and semi-government bonds for local investors, and then people move into things like hybrids thinking they’re a fixed income investment when, you know, there’s a lot of equity risk behind that potentially that probably they’re not getting rewarded for.

Andrew Main: Could we talk about commodities? The two commodities that exercise people in Australia are iron ore and oil. Now, Robert, I think you’ve just been in Saudi Arabia, so you’re probably better equipped to talk about what’s going to be happening with the oil price than the rest of us.

Robert Parker: What’s happening in the oil market at the moment is fascinating because it’s unprecedented. And the reason why I say it’s unprecedented is because we have now the advent of the shale industry as a threat to the traditional energy market, which of course is dominated by Saudi Arabia.

And over the past year, and most notably in the second half of last year, we had this fight for market share between Saudi Arabia and the other major Gulf producers and the shale industry. Now, what’s interesting about the oil market is the speed with which the shale industry can cut back on production or, when prices rise, increase production again.

That is unprecedented because if you look at the conventional oil industry, let’s say we’re developing offshore oilfields or even onshore, it takes many years to develop a new field. With the shale industry, the economics are such that they can actually develop new fields very quickly indeed. Now, that means we’ve got some natural stabilisers because if the oil price goes back, let’s say if we look at North Sea Brent as a benchmark, and the oil price goes back to $US70 to $US80, that immediately improves the economics of shale and production will come on line.

Likewise, if the oil price goes down to $US40 per barrel, the shale industry economics get destroyed quite badly and production stops and therefore we’ve got a natural floor on the oil price.

So I think we’re now stuck in a range of $US40 to $US80. I think that’s actually good for the global economy because less volatile energy prices actually mean that economies can have actually a much higher degree of certainty.

Andrew Main: Certainly most users of oil would be pretty comfortable at those prices.

Robert Parker: If you compare oil prices today with where we were a year ago, and Brent peaked at close to $US120 per barrel, this is a huge boost for consumers worldwide and a huge boost for countries in Europe and countries such as Japan, India and, for that matter, China, who are consumers of energy.

It’s not good news for the exporters of energy.

Andrew Main: But what I think you’re saying really is the price of oil is somewhat more controllable by the natural market than the price of iron ore, because the problem we seem to be having here is that Australia is not the only large producer of iron ore; the biggest single producer is Vale in Brazil.

The two next biggest are BHP and Rio in Australia, and there’s a fair degree of discomfort in Australia at the moment about whether or not the government should become involved in investigating whether something should be done to shore up the price of iron ore.

David Murray: It’s not clear to me where the market failure would have been to justify intervention. Typically intervention can be justified where markets become monopolised, but people trying to increase … I mean a monopoly producer does not increase production when prices are low. A monopoly producer holds production. So people increasing production because they can still make a margin or return is not indicative of market failure, and therefore the case for intervention seems to be absent.

Robert Parker: One has to look at your key competitor in the iron ore market ... and emphasise that Brazil, really the last two years, has been under extreme pressure.

To give you an example, Brazilian GDP growth this year will probably contract by 1 per cent and unemployment is rising, consumption is under pressure, and clearly they’ve got a problem coming back to the oil market with corporate governance and other issues at Petrobras.

So, if you compare Australia with Brazil, you’re comparing yourself with a reasonably comfortable economic situation with at least reasonable, positive growth this year with your key competitor, which is a very stressed competitor. You have a look at the behaviour of Brazil in that context.

What’s happening in the Chinese economy, I think, is absolutely crystal clear, which is they are concerned about deflation. That means the monetary policy in China will be very easy. They’ve cut prudential reserve requirements. They are cutting interest rates. That is a major factor in fuelling the Chinese equity market.

We have been positive on the outlook for the Chinese equity market now really for about the last year and we remain positive on the Chinese equity market, so I think that loops back in to a positive outlook for the Chinese economy.

David Murray: There are three moving parts for the Australian economy. There’s the rate of growth in China generally. There’s the extent to which that growth in China is tilted towards demand for iron ore, so it’s the shape of the growth. But the most important one to consider from now on is for every percentage point change in the mix of growth from investment to consumption, there is lower demand for Australian iron ore.

David McDonald: There are opportunities for Australia in other areas. Iron ore is by far our biggest export and that’s the one that’s probably not going to grow very much. Tourism, education, things like that are all growth markets as China becomes wealthier ... but, you know, we’ve got many competitors in those areas.

David Murray: The policy issue is with the reduction of investment in Australia, the end of the mining investment phase, will we have converted it into new productive investment with policies that drive higher productivity, or will we have participated in asset momentum in housing and equities without highly productive new investment?

Now, being capital dependent on the rest of the world, it’s important that we’re more careful with investment and that we make it as productive as possible.

So I see an issue with housing because there’s so much momentum there. In the equity market — it’s the same as the problem globally — (and the question is) can that momentum be managed? People are making rational decisions, but can it be managed?

India is a bit of a sleeping giant for us, positive.

And the other biggest disrupter is the digital world and that will have very profound implications for a long time yet, and we’ll have to get used to seeing great company names that we’ve got to know and love potentially disappearing from disruptive new technologies.

My policy always is, turn and attack, but it’s not that common and I think an established company has got to use the power of its brand and combine it very aggressively with digital technology if they’re going to see off some of these new models, and that typically doesn’t happen.

To watch a video of the roundtable go to theaustralian.com.au/ business.