The film Apollo 13 dramatizes the challenging lunar mission and depicts how the spacecraft’s astronauts acted quickly and devised a strategy to get home safely in a chaotic and unforeseen environment. In a tense scene, the gimbal navigation system1 became locked and the astronauts were forced to use unprecedented action to stay on course. Too steep an entry back to Earth and they would burn up; too shallow an entry would lead them to skip off the top of the atmosphere and back into space. Fortunately, they judged it right and they were able to land safely. The macro and capital markets have a similar tense and unexpected feel.
Staying on course in a complex, fast-moving environment requires flexibility from policymakers and market participants. Central banks are faced with a fine balancing act: go too strong on interest rates and there is a risk of stemming fragile growth. On the flip side, too little correction and inflationary pressures could get out of hand. Add into the mix escalating geopolitical and economic tensions associated with Russia’s invasion of Ukraine, volatile markets, supply chain shocks and slowing global growth and we have a macro environment which feels untested and unfamiliar.
Securities lending endured the same unfamiliarity at the start of 2022 with heightened volatility associated with a wide market sell off. BBH’s securities lending team noted that volatile capital markets could create challenging market conditions with investors seeking to refocus on fundamentals.
In Securities Financing in 2022: Hold on Tight! we highlighted that investors were increasingly looking past the pandemic and we expected to see a shift in focus where risk assets begin to trade more on fundamentals as we moved from Quantitative Easing (QE) to Quantitative Tightening (QT).
Overall, despite the relatively muted start, we noted that there would be more conviction in terms of lending demand and activity would broadly increase. As we look to the second half of the year, we believe many of these themes will continue but we also expect several opportunities in certain markets and asset classes.
China’s “Zero Covid” strategy with targeted lockdowns in major cities in H1 2022 to clampdown on Covid infections impacted both regional and global economies. The impacts were particularly felt in sectors such as hospitality, retail, and travel.2 The regulatory controls that focused on the technology sector and curtailing debt bubbles in real estate and property led to wide market sell offs. Although pressure has recently abated for some firms, broader risks remain. Separately, investor de-grossing and reduction in leverage resulted in lower balances and a narrower demand profile in the region. Capital raising activity in Hong Kong slowed down considerably as new issues and secondary offerings were hampered by market volatility, rising interest rates, and geopolitical tensions.
Going forward the Chinese authorities are expected to stick to “Zero Covid” in the short term, which will likely impact the broader economy and provide us with similar sector-specific themes to those mentioned earlier. Capital raising across APAC could be challenging in the second half of the year given the macro environment; however, the delisting of Chinese firms in the U.S. to Hong Kong may accelerate in late 2022 or early 2023. This could provide some impetus for lending demand towards year end. In South Korea, a broader relaxation of the short selling rules may be permitted in late 2022 outside of the Kospi 200 and Kosdaq 150, which will likely boost lending demand.
Airlines and travel firms have faced continued headwinds post-Covid due to the conflict in Ukraine and retaliatory sanctions imposed by Russia putting strain on global fuel costs. Several European airlines have also had large EU-imposed fines to contend with after a cartel scandal dating back to 2006 during which cargo carriers plotted to fix the level of fuel and security surcharges over a period of six years.3 Air France, Finnair, International Airlines Group, Lufthansa, TUI and SAS (Scandinavian Airlines) are several airline securities that have seen strong securities lending revenues this year. Real estate has also seen robust lending returns during the first half of the year, including Luxembourg based Adler and Swedish firm SBBB. Capital raising remained strong in the first half of 2022 with several notable rights issues. Demand was seen for Air France, Billerud Korsnas, EDF Energy, Faurecia, Karo Pharma, and Millicom International. Finally, two key specials that drove high revenues were German battery maker Varta and distressed Italian bank Monti dei Paschi.
It was an extremely challenging start to 2022 for U.S. equities with the S&P 500 entering bear market territory by June. The core themes dominating investor sentiment remained the evolving nature of the pandemic, the Federal Reserve’s reaction to rising inflation and concerns around slowing growth. Simultaneously, investors reallocated and deleveraged their portfolios, particularly on the long side, as a more risk-off environment took hold.
Despite the prevailing volatility, the less correlated asset pricing and a more fundamental focused environment did offer some resilience on the short side as investors took a more hedged view. This generated some positive momentum creating a depth in the hard to borrow market in the U.S. Most notably the demand concentrated on the “Meme Stocks”,4 such as AMC Entertainment and GameStop, which continued to attract attention and command high fees.
Elsewhere, event driven demand, namely SPAC deal closures and IPO lockup expiries generate a significant source of lending revenues. Companies such as AdTheorent, Lucid Group and Rigetti Computing were in high demand as investors looked for exposure to these deal situations.
In Canada, the first half of 2022 saw a modest rebound after a relatively lackluster end to 2021. While the cannabis sector remains a popular thematic trade, a return to the highs of 2019-2020’s lending returns may prove challenging due to its low asset valuation. We also witnessed a broadening in terms of Canadian sector plays as investors have expressed conviction this year in crypto, electric vehicles, real estate, and various forms of mining including lithium and uranium.
In the corporate bond space at the macro level, we have seen an uptick in utilization for the sector versus previous years as central banks around the world increased interest rates putting significant pressure on pricing and spreads across both the investment grade and high yield spectrum. Long dated issues, as well as perpetual bonds, have been growing in demand given their weakness further down the yield curve. On a micro level, American Airlines and United Airlines saw several of its issues in the first half of the year become a focus of lending demand as fuel costs and reduced services impacted their bottom lines.
With so much on the table, it’s difficult to see a clear path forward. Capital markets and policymakers alike are dealing with unique and unseen challenges. What this is likely to mean is that the themes and trends will become increasingly dynamic, fast paced, and be more targeted. There will continue to be divergence between global policymakers and risk assets will be more uncorrelated and disparate. This environment will likely lend itself well to more active and hedged allocation and ultimately drive securities finance demand well into the second part of 2022.
The prospect of further interest rate increases will create additional opportunities generated by the continued volatility and increasingly the impact to corporate earnings. Supply shocks and inflationary pressures will likely single out winners and losers which will lead to an uptick in fundamental stock picking.
Elsewhere, credit spreads will likely push heavily leveraged firms to raise capital via equity offerings and debt restructurings, which in turn will generate opportunities. We also expect continued focus on credit and corporate bonds as these asset classes increasingly come under pressure. Overall, we are in for a period of significant adjustment and, much like the astronauts onboard Apollo 13, investors are going to have to adapt quickly to these unfamiliar surroundings.
1 A typical gimbaling inertial navigation system, such as might be used on board a missile, uses three gyroscopes and three accelerometers. The three gimbal-mounted gyroscopes establish a frame of reference for the vehicle’s roll (rotation about the axis running from the front to the rear of the vehicle), pitch (rotation about the axis running left to right), and yaw (rotation about the axis running top to bottom).
4 A meme stock is a stock that gains popularity among retail investors through social media.
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