Securities lending demand faced unprecedented challenges in the first half of 2020. Despite the market turbulence, we remain cautiously optimistic, even as the election cycle ramps up in the U.S. Here we look back at the first half of 2020 and explore some of the possible outcomes for the second half of the year.
At the start of 2020, the securities lending market was shaping up to focus on the ramifications of Brexit and the ongoing trade war between China and the U.S. While we anticipated that matching the asset returns of 2019 was going to be a challenge, particularly in equities, we expected a move to more diverse risk asset returns. This, in turn, was expected to result in an increase in securities lending demand with greater conviction from stock pickers to counter what had been a decade long, sustained market rally. Instead, we are faced with unprecedented central bank stimulus, ultra-low interest rates and a deteriorating fundamental outlook. What has become apparent is that since the first reporting of cases in late 2019, COVID-19 has now affected a significant part of the world population and left an indelible impact on the global economy.
2020: Mid-year look back
Similar to the trend in the global economy, the impact of the pandemic in Asia has been severe for travel related firms. As such, we saw increased demand for Cathay Pacific Airways, Corporate Travel Limited, Flight Centre, Singapore Airlines, and Webjet, as they sought funding from governments or through the equity markets in order to mitigate the effects of their depleted balance sheets.
In Hong Kong, we also witnessed an increase in demand for locally listed Chinese ETFs during March’s market volatility as investors sought broad exposure in the domestic ‘A’ share market. Despite the dual challenges of the pandemic and increased political tensions, both locally and between the U.S. and China, lending demand remained steady in connection with a stream of capital raising deals. Most notably, prominent Chinese firms trading in the U.S. such as JD.Com and Netease Inc. raised capital through secondary listings in June. We expect to see an increase in IPO activity for Chinese firms listed on U.S. exchanges on heightened concerns of potential delisting in the U.S. given ongoing tensions between the two countries.
Securities lending demand in Japan and South Korea had weakened in the first half of 2020. In Japan, the combination of deleveraging of long term specials and increased lending supply had resulted in lower demand during the first quarter of 2020. The cancellation or reduction of many dividend payments by Japanese companies adversely impacted lending demand. In South Korea, demand for borrowed securities has been negatively impacted by the 6-month ban on short selling imposed from March 16, resulting in lower volumes and fees of long-term specials.
From a European perspective, the economic picture is challenged with data showing a reduction in core inflation, industrial production, and retail sales. From a securities lending perspective, one of the biggest stories has been Wirecard AG, a long-term directional special that was referred to as the “European Enron”. On June 18 the company’s share price tumbled after auditors failed to confirm cash on financial records totalling $2.1 billion. Following the collapse of the company, which has been a big reputational blow to Germany, the financial regulator BaFin was appointed to investigate how a failure of this magnitude could take place.
Additionally, we have seen a strong increase in fees and short directional demand in the airline and travel industries in the likes of Air France, Easyjet, Finnair, Deutsche Lufthansa AG, and TUI AG. We are also witnessing a stronger short interest base in the luxury goods sector such as Remy Cointreau and Tod’s. Broader directional interest has also been present in the automobiles and manufacturing industries. However, as securities in these sectors remain well supplied in the lending industry, we are not seeing a material change in lending fees.
We have already seen a flurry of companies needing to secure capital to shore up their balance sheets via rights issues. There are indications of an increase in M&A activity with Just Eat Takeaway announcing a stock acquisition of Grubhub. Whilst we do see more companies currently choosing to raise capital, we also expect a further increase in M&A activity as the year progresses and companies increasingly digest the impact of COVID-19 and evaluate their strategies for long-term success.
In the U.S., the first half of 2020 has truly been unique. The year started on a quiet note, with demand at moderate levels. However, once the market sell-off began in the first quarter, we saw short interest increase and borrow demand grow in the sectors where the pandemic had its greatest effect. Interest was particularly strong in leisure and travel companies such as Carnival Cruise and Royal Caribbean, as well as American Airlines, car renters Avis and Hertz, and retail chains such as Macy’s.
We have also seen broader directional interest in some sectors or regions such as the leveraged loan markets (Invesco Senior Loan ETF), the oil sector (United States Oil Fund), as well as Russian (Vaneck Russia ETF) and Chinese indices tracking securities (XTrackers Harvest CSI 300). Demand to borrow ETFs was at historical highs, specifically at the onset of the market sell-off, as investors sought to hedge broad market exposures.
Over the course of the first half of 2020, we also had two lucrative corporate event trades that provided strong returns. Firstly, demand spiked for McKesson Corp, a pharmaceutical conglomerate, as it was spinning off one of its subsidiaries, Change Healthcare. As this was a discounted voluntary action, investors were able to arbitrage the offer, and shares were in high demand. And Match.com completed its separation from its parent company IAC, producing one of the highest yielding trades thus far in 2020.
Fixed income lending for the first half of 2020 has been rather mixed. While there has been heightened demand for high quality government debt, corporate debt was more subdued. Much of the demand for sovereign debt has been U.S. Treasuries, which benefitted from short term spread widening due to elevated cash collateral yields relative to overnight rebate rates in the wake of unexpected and significant Fed easing. The stress and volatility in the credit markets since the beginning of 2020 hadn’t resulted in an increase in revenue for the investment grade and high yield sector.
As governments around the world have started to relax lockdown measures, we may see the entertainment, health and fitness, and travel industries rebound. Additionally, we may expect a similar trend in the manufacturing industry especially as governments look to increase consumer spending to revive economies. The timing and degree to which government stimulus will be removed is uncertain but will ultimately foster greater fundamental asset pricing and create opportunities for stock pickers.
From a securities lending perspective, we are cautiously optimistic. We expect that companies will increase their activity in corporate restructuring as M&A, IPOs, and capital raising look to increase in the second half of the year as pent up demand returns. And there remains the impact Brexit and a U.S. presidential election may have on capital markets, which we believe to be a positive tailwind for increased returns from securities lending.