During the first half of 2021, we witnessed a substantial change in perspective in global stock markets as a post-COVID recovery world began to emerge. The announcement of successful vaccination trials provided much needed hope and many investors began to refocus on the fundamentals of companies and their earnings potential. The emergence of a tentative global economic recovery, the impact of further central bank stimulus, as well as the return of corporate and consumer confidence, increasingly drove investor sentiment.
Looking back at the first half of the year, the narrative was quite remarkable. Key events such as the U.S. presidential election and the conclusion of Brexit were quickly pushed aside. Instead, two duelling events defined the first half of the year. First, the rise of retail investors spurred on by social media sent markets in a frenzy and then several weeks later, the default of a highly leveraged family office shaped much of the commentary and had significant influence on securities lending demand during the period.
Although these events now appear to have been relatively contained, they have had an impact with institutional investors becoming increasingly cautious in managing concentrated exposure. In addition, there has been increased regulatory focus on disclosure rules, as well as the potential need to increase oversight and limits on leverage due to the potential for systemic impacts. The long-term effect of additional regulatory rulemaking could have a dampening effect on demand in the months ahead.
In the second half of the year we expect the focus to shift back to investment fundamentals, buoyed by continued reopening of world economies. We expect attention will be drawn to central bank monetary policy, with a focus on potentially dialling down pandemic-related stimulus, growth of inflationary pressures, and investors positioning towards a post-pandemic world. What these themes may likely drive is an element of divergence in terms of asset pricing across market sectors, regional responses to the pandemic, and the various trajectories of growth across economies. In this type of environment, we typically witness increased securities lending opportunities as risk assets may become less correlated which in turn should provide opportunities for stock pickers. Separately, continued ultra-low interest rates present a more accommodative financing environment, as pent up demand for deal activity starts to accelerate.
U.S. and Canada
In January, a tumultuous week spurred by outsized retail trading activity may have reshaped the way institutional investors viewed their short exposure. In the early weeks of the year, the market saw a horde of online retail investors band together to drive up the price of GameStop, as well as other short positions in the retail and entertainment industry such as AMC Entertainment and Bed Bath & Beyond. This flurry of buying from the retail side created a short squeeze, when a heavily shorted stock has a rapid rise in price, as trading platforms scrambled to shut down the activity for fear of not having enough liquidity to meet margin calls. The combination of the short squeeze and the inflated price action drove on-loan balances higher and enabled many asset owners to benefit from twin dynamics of rising stock prices and meaningful securities lending revenue.
This event sparked some concern across the financial markets as this type of coordinated market activity was unprecedented. Many investors, particularly hedge funds, likely reassessed the scope of their own short positions, which could have contributed to reduced lending activity. This low demand environment lasted for nearly two months until we began to witness small signs of increased lending demand. The slow-burning recovery was led initially by stronger demand for ETFs, particularly high-yield bond ETFs, which are increasingly being used as an efficient hedging tool.
By mid-May we began to see demand spread back to single stock names, notably in the electric vehicle, consumer discretion, and information technology sectors. Securities of interest were Blink Charging Co, Nikola Corp, and Workhorse Group Inc in the electric vehicle sector, Palantir Technologies in the IT sector, and AMC Entertainment, Tilray Inc, and Rocket Companies Inc in the consumer discretionary sector. Finally, a varied line-up of special purpose acquisition companies, or SPACs, continued to create demand in the lending market due to their recent sub-par performances in the wider market.
In addition, a material taxable spin-off trade for International Fragrance and Flavors (IIF) from Dupont closed in March, generating significant revenue for securities lenders. Dupont shareholders had the option to convert their shares into IFF common stock at a significant discount to a price stated at the outset of the transaction. This was an attractive deal for securities lenders, illustrating that general collateral securities have the potential to rapidly generate premium fees depending on demand dynamics.
In Canada, buoyant retail investor sentiment in the cannabis (Canopy Growth) and mining sectors (Americas Gold and Silver), as well as “meme stock” Blackberry drove an overall decline in short interest across the Canadian hard-to-borrow market in H1.
Demand for Canadian cannabis firms continued to persist in the face of pressure related to increased regulation and cost pressure weighing on margins. Overall, the cannabis industry has struggled to access traditional funding channels, which created trading opportunities when firms raised capital via secondary offerings. We expect deal activity in the sector to be robust in the second half of 2021 as Canadian firms look to consolidate to stave off competition from new entrants.
Our outlook for the U.S. and Canada is sustained Demand in the electric vehicle and consumer goods sectors, as well as broader interest in ETFs, is expected to continue. We are also closely watching the scarcity of lumber, and key participants in the automobile manufacturing chain. We expect new housing projects as well as overall production in the auto sector to falter. Of importance to a sustained recovery will be the progress of vaccinations and the frequency of outbreaks of new strands of COVID-19. Any resurgence and reversion to the pandemic state could generate increased borrowing demand in the auto rental, retail, and travel/leisure sectors.
We expect the deal pipeline to remain robust as pent up demand and an attractive financing environment continues to drive activity. For example, Dell announced it would be spinning out VMware as part of the EMC acquisition back in 2015, with an anticipated Q4 2021 transaction date. There is no optionality or arbitrage opportunity in this deal as it is a mandatory spin-off, though strong demand has persisted, allowing end users to borrow VMware at favorable rates through completion of the deal.
Another key opportunity could be a tax efficient, Reverse Morris Trust transaction whereby AT&T and Discovery announced a deal to combine Warner Media’s and Discovery’s entertainment, sports and news businesses, spinning them off into a separate company. The transaction is not expected to be completed until 2022 but demand throughout 2021 should persist.
Securities lending demand in Asia was largely dominated by capital raising activity in Hong Kong, which was particularly robust in the first quarter of 2021. As of early June, just under US$24 billion had been raised through IPOs in Hong Kong, marking the best start to the year for new equity issuances (source: Bloomberg, Dealogic). In addition, there were a flurry of secondary placement deals and convertible bond issuances which helped drive healthy lending returns. High profile deals which attracted strong interest included IPOs by Baidu Inc, Bilibili Inc., and a US$3.8 billion placement by electric car manufacturer BYD Co. in late January.
Spurred on by abundant liquidity and strong inflows via the Stock Connect market access program, Hong Kong’s equities market rallied significantly into mid-February. With valuations stretched and increased regulatory scrutiny, however, we witnessed strong lending demand in several education, online healthcare, and technology companies. Lending demand increased for Koolearn Technology, Ping An Healthcare and ZhongAn Online P&C Insurance as due to significant price corrections post the Chinese New Year break. In addition, strong directional activity was also seen in Gome Electrical, Flat Glass Co, Hengten Networks, Nongfu Spring Water, and Tianneng Power after they witnessed significant rallies in the beginning of the year.
The much-awaited resumption of short selling in South Korea — currently limited to the Kospi 200 and Kosdaq 150 indices — was delayed to early May 2021. Upon the lifting of the ban the lending market witnessed a broad pickup in demand across the biotech, electronics, gaming, healthcare, and pharmaceuticals sectors.
Lenders in Malaysia and Taiwan were able to generate strong returns thus far in 2021. The dominant theme in Malaysia was in the rubber gloves manufacturing sector led by Hartalega, Supermax and Top Glove after strong share price gains in this sector in 2020. However, these valuations have been tested this year as concerns over forced labor practices at these firms have surfaced, which in turn has led to increased scrutiny by investors and regulators alike. In Taiwan, lending demand was largely driven by directional interest in the shipping and technology sectors as a result of increased asset valuations. Securities lending demand was dominated by Acer Inc, AU Optronics, Evergreen Marine, Wan Hai Lines and Yang Ming Marine.
Looking to Australia and Japan, both capital raising and specials activity were broadly subdued though there were pockets of demand in stock specific securities. Australian specials were driven by long-term directional names such as Bubs Australia, Mesoblast, and Myer Holdings, while in Japan there was continued directional activity interest in AI Inside, Anritsu Corp, Makuake Inc and Neural Pocket Inc.
We expect capital raising activity in Hong Kong to be comparatively muted in the second half of the year. Monetary tightening in China, increased regulatory oversight across several sectors and the relatively poor performance of several recent listings may result in fewer IPOs and secondary deals than seen in Q1. However, increased tensions between the U.S. and China and the potential for listings to move away from the U.S. to Hong Kong may help spur lending demand towards Q4. In addition, there are still broader themes that are continuing to drive lending activity such as increased regulatory focus in the Chinese education, healthcare and technology sectors. In South Korea, we expect lending activity to pick up pace though much will be dependent on whether short selling will be expanded to the broader indices.
European lending demand was relatively muted in the first half of the year primarily due to the impact of investors repositioning as a result of the increased activity of retail investors that subsequently resulted in significant reduction of short positions. Europe’s top short positions such as HelloFresh, Takeaway, Unibail, and Varta all saw declines in demand as investors looked to reduce their leverage and exposure.
In addition, themes in Europe have so far remained largely as predicted with the effects of the pandemic and its associated restrictions continuing to weigh on the economy, industrial production, and retail sales across Europe. Though vaccine rollout has been largely successful, continued headlines around new variants and regional lockdowns have provided no respite and as we saw the end of restrictions in the U.K., signs are beginning to point to delays in the relaxation of rules, particularly around international travel. As such, demand for borrowing in travel and tourism continues to remain strong with the likes of Air France, EasyJet, Finnair, Deutsche Lufthansa, and TUI all in strong demand.
Elsewhere in Europe, we have observed a continuation of event driven demand as companies begin to recommence dividend payments and continue to focus on the strengthening of cash reserves or making the most of the low interest rate environment to fast-track acquisitions and consolidation plans. Borrowing demand on the back of rights issues have included Euronext, Deutsche Beteili, Neoen, Obrascon Huarte, and Vallourec. Additionally, convertible bond activity has been a relatively strong source of capital raising with focus names such as Credit Suisse (EU 2 billion), International Consolidated Airlines Group (EU 825 million), Engie (EU 300 million) and Jet2 (£387 million) all announcing issuances.
Event driven demand should remain strong in the second half of the year as companies continue to look for ways to grow and position for a post-COVID recovery economy. We believe that the borrowing demand in the travel and tourism sector that has occurred over the past 18 months will continue as we enter the key summer months. With significant travel restrictions in place for the foreseeable future, it’s difficult to foresee positive headlines for the sector in the short term.
Finally, we continue to monitor news and any associated demand in relation to the global chip/semiconductor shortage which is disrupting large car manufacturing targets and is likely to spill into other consumable production such as laptops, games consoles, phones, and tablets. Businesses have already started to warn shareholders of their ability to meet production and sales targets and with the shortage potentially lasting until as far as mid-2022, we could see associated increases in lending demand for affected sectors.
Corporate Fixed income
Continued demand for real estate debt featured heavily in the first half of the year with China Evergrande and Unibail Rodamco commanding outsized demand. Producers such as American Axle & Manufacturing, Kleopatra Finco, and Tutor Perini, highlighted the demand for industrials and hard-hit sectors such as airlines remained in demand with issues from United Airlines in focus.
Looking at the second half of the year, we expect many of the sectors observed in the first half of the year to be in focus with consumer cyclical, industrials, and real estate topping the list. The continued focus on inflation from central banks is another area we anticipate will result in increased activity across both assets classes with long dated issues and perpetual bonds a potential focus for short sellers.
Overall, we expect demand to remain healthy in the second half of the year, although we anticipate the typical softening of activity during the summer period. The corporate deal pipeline remains strong and is expected to provide increased opportunity for investors. ETF demand continues to grow commensurate with the overall asset class, remaining robust and we expect sector demand specifically in the electric vehicle (EV) and technology sectors to drive opportunities. Key specials activity, which have been driven by the impact of the pandemic, will likely remain as the associated risks of unlocking continues to prevail. Separately, investors continue to remain cautious of concentration as a result of the Wall Street and meme stock phenomenon although there are signs that targeted short conviction is increasing, with accompanying opportunity for increased returns from securities lending.
References to specific securities and financial markets are for illustrative purposes only and are not intended to be and should not be interpreted as recommendations.