For some commentators, this year has had it all! It was the year that Apple Inc. became the first public company to reach the $1 trillion market cap level, the VIX nearly hit 50 for the first time since 2015, the cryptocurrencies bubble burst, global equity markets suffered a torrid time and Tesla Inc nearly went private. It was also a year where we faced unprecedented geopolitical news.
Chairman Kim Jong Un met President Donald Trump as South and North Korea looked to reconcile, Brexit turned from ‘hard’ to ‘soft’ (and perhaps ‘hard’ again?), trade wars broke out among the world’s super powers and China’s growth rate cooled yet again. A year which started on a relatively optimistic footing, began to look a little unsure about itself as we approached year-end.
From a securities lending perspective, 2018 has been a banner year with global markets offering our clients great opportunities to generate returns. In the first half of the year, steady growth was observed across all regions and global on-loan balances increased by 10% over the same period in 2017, more than offsetting a drop in average spread1. This, paired with an elevated level of volatility and greater economic uncertainty associated with events such as Brexit, led to a more diversified, stable and long-term set of loan opportunities across the program compared to 2017 where opportunities were in a concentrated number of stocks. Over the second half of the year, news headlines dominated the markets as trade-tariff based rhetoric, concerns about accelerated monetary policy in the US and a much-anticipated market correction in October caught many investors off guard, erased much of the gains experienced in 2018, and led them to take a ‘risk-off’ stance. This has led to a marked change in the lending environment, with a higher volatility in lending volumes and lending fees as fund managers look to de-risk, cut losses or take a ‘sit it out’ attitude.
In Asia this year, the securities lending market was driven by a combination of themes, not least by the escalation of the US/China trade war which led to an increase in volatility across the region. In Hong Kong, demand was buoyed by a strong pipeline of initial public offerings and broad capital raising activity, particularly in the e-commerce and technology sectors. In Japan, an increase in corporate scandals and M&A deals provided additional impetus for lending demand. Tightening in Chinese government regulations in the online game sector negatively impacted developers across the region, particularly those based in China, Japan and South Korea, which was further exacerbated by the selloff in the global tech sector in Q3/Q4 2018. Lastly, in South Korea, we witnessed robust demand in the biotech and pharmaceutical sector on investor concerns that these sectors were overvalued after a strong market rally that began in 2017.
In Europe, political uncertainty and a weak consumer environment proved to be key drivers for lending demand in 2018. Demand for retail providers, particularly in the UK, was strong throughout the year as several high street names announced store closures, restructuring plans and poor sales because of rising costs and poor seasonal revenue. In Italy, banks continued to face headwinds as the government put forward a budget that breached EU fiscal policy, sending bond yields higher placing increased pressure on the banks funding costs, many of which have significant exposure to sovereign issuance. Finally, across the continent, lending demand increased for companies within the construction sector as output fell, contract uncertainty grew and contagion from the collapse of one of the UK’s largest contracting firms, Carillion, led many to wonder what was in store for similar firms.
In the Americas, demand was driven by many factors, the foremost of which was the worsening consumer sector, as online giants such as Amazon continued to change the way consumers purchase products. The legalization of cannabis products in Canada has spawned a significant level of borrowing demand as speculation persists whether supply will match the amount of real demand. Many cannabis producers went public in Canada quite early on, post legalization, thus priming the market for mergers. Stock prices remain extremely volatile in this sector. Rising interest rates are putting short term corporate bonds under pressure, as many struggling corporations are finding it hard to meet their short-term obligations. As interest rates continue to rise, this will only intensify, and many Short-Term Bond ETFs are attractive to borrow as hedge funds short the sector. Other overarching themes observed in 2018 were largely geo-politically driven. Domestically, the trade war with China generated a lot of scrutiny as some companies with ties to Asia, or China specifically, came under pressure. Further, falling oil prices have created volatility in the energy sector as the depth of the price movements were not forecasted by many observers.
We expect lending demand to be steady in the first half of 2019, albeit masked with a little extra cautiousness. The recent market volatility has led to a period of de-risking and hedge fund performance in the second half of 2018 has come in below expectations. Additionally, several macro headwinds could negatively impact borrowing demand such as a rapid escalation of the US/China trade war, a sharp economic slowdown in China and an increase in political tensions across Europe (Brexit and Italy).
As we go into 2019, we see a much different economic landscape in the US than we did to start 2018. The predicted speed of rate hikes has decreased, Oil prices have dropped precipitously, and markets have been disrupted. As we head into 2019, the expectation is that funds will be active as they were to start 2018 but understanding of the new landscape. The Hedge Fund market saw minimal outflows and have seen many new high-profile start-ups in 2018. The expectation is for demand to be resilient in the first half of 2019.
From a thematic perspective, we expect Asian lending demand to be driven by several sectors which have faced challenges in 2018. In China, educational sector because of potential further regulation that will negatively impact private operators. Chinese automobile manufacturers as the industry is beset by a broad slowdown in demand for vehicles and South Korean pharmaceuticals on concerns that the sector is still overvalued.
For Europe, we expect many of the themes affecting lending demand to spill over into the new year with no respite expected for the retail markets which have suffered throughout 2018. We expect Brexit to continue to dominate headlines in the first half of the year as the UK Prime Minister seeks to close divisions within parliament and hopes to ensure that a deal is agreed prior to the 29th March deadline. The outcome of the final deal could have large ramifications for Aerospace, Automobile and Manufacturing industries in the UK and throughout Europe. More broadly, we continue to monitor macro influences associated with political uncertainty and market fundamentals.