The start of the decade has presented investors with a tale of two scenarios. On the one hand, escalating geopolitical tensions in the Middle East have ramped up market anxiety. On the other, potential trade resolutions between the US and China, as well as another Brexit deadline that — if both sides can agree — could mean an end to an extended period of uncertainty which has weighed upon investor conviction. This balance of optimism and pessimism couldn’t be more delicately poised.
The securities lending industry has entered an equally active period. The regulatory agenda continues to reverberate with the Securities Financing Transaction Regulation (SFTR) and the Central Securities Depository Regulation (CSDR) shaping market activity. Environmental, social, and governance (ESG) continues to gain attention as the industry looks to incorporate these principles with its broader agenda. Separately, technology will play an increasing role in securities lending programs and will ultimately drive the client experience in terms of transparency, control, and performance.
With regulatory uncertainty behind us and the macro factors outside of the industry shaping up to present both opportunities and challenges, the industry will likely focus once more on growth and innovation.
2019: A year in review
After a buoyant 2018, a year in which the industry saw one of the best returns since the 2008 financial crisis, securities lending demand in 2019 faced several headwinds. Chief among these were geopolitical risks such as Brexit, social unrest in Hong Kong, escalating tensions in the Middle East, and the ongoing US/China trade war. This, in turn, negatively impacted borrowing demand. Global revenue returned approximately $10.1 billion in 2019, representing a year-over-year decline of 6.3 percent.1 While specials activity was strong in North America, in part due to increased IPO activity in the US and robust demand in the Canadian cannabis sector, Asia and Europe both saw broad declines.
In North America, revenue from specials activity accounted for 31 percent of all securities lending activity in 2019, up from 25 percent in 2018.2 Early in the year, two large deals represented the bulk of the activity. Dell Technologies repurchased its tracking shares and pharmaceutical giant Eli Lilly spun off their holdings of Elanco at a discount. These deals, coupled with continued directional interest in the Canadian cannabis sector, were primary drivers for demand.
Just prior to mid-year, directional demand picked up as a flurry of high-profile IPOs came to market – Beyond Meat, Lyft, and Uber, to name a few. Demand for these new share issuances was robust and built momentum in the market that carried through the summer months into Q4, only to recede after lock-up periods expired for these securities.
In Asia, corporate deal activity was generally subdued compared to the previous year, which in turn had a negative impact on revenue, which declined by 8.7 percent year-over-year.3 However, there were several high-profile IPOs in the last quarter of 2019 — most notably Alibaba and Budweiser’s listings in Hong Kong — which helped boost demand, albeit briefly. Despite a broad reduction in deal activity, we did witness continued directional interest in several companies in the Chinese automobile, e-commerce, and technology sectors, such as BYD, Meituan Dianping, and Xiaomi Corp. In South Korea, demand was softer than in previous years, but there was robust interest in the biotech and pharmaceutical sectors, led by HLB and Sillajen, spurred by investor concerns that these sectors continue to be overvalued. Finally, in Japan, lending demand was largely driven by directional demand in specific companies in chemicals, liquid display manufacturers, and robotics where Cyberdyne Inc. was a standout performer.
In Europe, revenue declined by 20 percent year-over-year,4 but demand for specials increased on the heels of significant IPO activity and private equity takeovers in Germany. There was robust interest in Osram Licht, a multi-national lighting manufacturer, after numerous failed potential takeover bids. Demand for Wirecard AG increased after numerous reports of accounting irregularities were published by the Financial Times, resulting in an unprecedented short selling ban. In the UK, there was strong securities lending demand for Sirius Minerals after the miner announced a convertible bond sale following a failure to secure the funding required to continue operations as planned. In France, Casino Guichard, and its parent, Rallye, saw increased securities lending demand as the supermarket group looked to reduce debt by selling stores.
Separately, fixed income returns also lagged year-over-year with the supply of government bonds catching up with the demand for Hiqh Quality Liquid Assets (HQLA). There was also a reduction in the spread between the traditional USD/JPY pair trade, a common driver of treasury demand, as well as pan European government yields reducing throughout 2019. US government bond lending revenues fell by 20 percent year-over-year, with international government bond revenues falling 21 percent.
In the corporate lending space, a reduction in US interest rates saw a strong performance in the credit markets for 2019 and that, coupled with an increase in lending supply and lack of conviction from hedge funds, meant revenue was down by 17 percent from the highs of 2018. There were, however, some bright spots in 2019, with the energy and pharmaceutical related issuers providing significant lending returns. Balances were flat year-on-year, meaning much of the reduction in revenue was due to the suppression of lending fees, leading to a total revenue of $604 million for the year. It is worth noting that although a reduction from last year, 2019 returns were the third highest we have seen in the space behind the highs of 2018 and 2017.
Hedge fund performance in 2019 was rather mixed with performance varying across regions and strategies, which in turn impacted demand. Although hedge funds delivered their strongest returns since 2009 with a return of 10.4 percent for the HFRI Fund Weighted Composite Index, this lagged against the 29.1 percent gain for the S&P 500.5 As of October 2019, long-short equity funds saw redemptions of almost half of the approximately $88 billion that was redeemed during the year while quant strategies saw mixed returns.6 The bright spots have been in some Asian focused and event-driven funds which saw inflows in 2019.
Looking ahead to 2020, we remain cautious with regards to securities lending demand, particularly as we enter an election year in the US. To date, the looming US election has not meaningfully influenced demand, although geopolitical issues have weighed on sentiment. It does appear likely that this will change as President Donald Trump may increase his rhetoric, which often has a whipsaw effect on the markets. Further, as we gain clarity on who the Democratic Party challenger to President Trump will be, we should understand the impact on the markets, as there are several candidates who could be seen as adversaries of the pharma, big tech, and financial sectors. Specifically, some Democratic candidates are looking to impose sanctions on compensation for executives and create stricter trading guidelines around short selling and corporate events.
We expect the recent wave of merger and acquisition activity to continue in the US, as the economy is on reasonably strong footing, corporations are flush with cash, and funding is still readily available given the prevailing low interest rate environment. This may result in increased lending opportunities for asset owners.
As fears of a recession in the US have somewhat abated for now, the Federal Reserve is likely to keep interest rates steady after three cuts in 2019, which should provide further support to equity markets. The lower range should ensure investors remain invested and focused on equities. This is a positive for securities lending, as activity in the equity markets will continue, such as a robust IPO market, equity spin-offs, and capital raising through share issuances while market values remain high.
Canadian cannabis stocks face continued regulatory and political risks as market oversupply triggers firms to rein in capital expenditures, write down assets, and raise capital that often dilutes equity value. Cannabis sector lending fees should remain elevated in the near to mid-term, but revenues are largely contingent upon volatile mark-to-market loan valuations.
We expect demand to be driven by similar themes that we have seen in the past few years. The Chinese educational sector is still in focus because of potential further regulation that will negatively impact private operators. Chinese automobile manufacturers also remain of interest as the industry is beset by a broad slowdown in demand for vehicles. In South Korea, the biotech and pharmaceutical sectors are expected to generate strong lending demand on continued concerns over valuations in these sectors. The pipeline for IPO launches in Hong Kong is strong and we expect activity to continue in the first half of 2020. This will be a positive for a market reeling from heightened political tensions and a slowdown in the local economy.
In Europe, we’re off to a strong start to the year from a corporate events perspective. Securities lending demand has remained strong for Iliad and Takeaway with completions of their merger and acquisitions in Q1. We maintain a close watch on the automobile industry with focus on Fiat Chrysler, Peugeot, and Renault, after all engaged in merger talks last year. With concerns over a UK and European economic slowdown, we could potentially see more companies needing to raise capital via rights issues to sure up their balance sheets.
Moving to fixed income, we expect 2020 revenues to trend along the same lines as 2019. In the US, a tightening of the funding market towards the end of 2019 meant that the Federal Reserve stepped in to provide additional liquidity in order to reduce volatility in short term funding rates. This additional supply is likely to mean the demand for US treasury and government bond lending to stay relatively muted year-on-year.
An interesting space to watch could be in Europe as the progression of Brexit negotiations accelerates. Brexit – and the reaction from the EU – could potentially have an impact on yields across markets and sectors. This potential pricing dispersion could generate lending opportunities.
In summary, many market participants are predicting that the asset returns of 2019 will be difficult to repeat, particularly in equities. This view, coupled with the expectations of increased, albeit slow, economic growth throughout 2020, means we can expect returns to come from a more diverse asset range. This muted and potentially dispersed asset return environment could create improved conditions for stock pickers, both on the long and short side, and could potentially increase lending opportunities. More broadly, as we move through 2020, we expect securities lending demand to continue to be influenced by the impact of geopolitical risk. This influence could help investor sentiment and conviction or, on the flip side, keep investors on the sidelines until clarity prevails.
Past performance does not guarantee future results.
The views expressed are as of January 16, 2020 and are a general guide to the views of Brown Brothers Harriman (“BBH”). The opinions expressed are a reflection of BBH’s best judgment at the time and are subject to change without notice. This material should not be construed as research or as investment advice, nor should it be considered information sufficient upon which to base an investment decision.
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