Outlook: May You Live in Interesting Times

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As we begin the year, our attention turns to the themes which will likely drive securities lending demand over the coming months. In so many ways, 2016 was a fascinating year in terms of global macroeconomic and political events that both shaped the markets and created significant opportunities for our clients and their securities lending programs.

Our thought is that 2017 will be no different. In this update we provide some insights into the key macroeconomic events that will influence securities lending programs and predict what sectors may be in focus. Common themes across all regions will likely include the impact of rising interest rates in the US, a potential increase in dispersions in the equity markets and the lingering influence of political events on the global markets. Whatever happens, we expect unprecedented levels of uncertainty, which we believe will be an important driver for new trade ideas and new securities lending opportunities.

GLOBAL MACRO THEMES

Political Instability: Following the turbulence of Brexit and the consternation around the Italian referendum, investors are expected to turn their focus to other nations. France, Germany, and the Netherlands are all facing general elections this year. This brings a real threat of further unpredictability as established orthodox policies are replaced by a more fluid populist narrative, potentially impacting growth and the structural integrity of the Eurozone. Separately, as a new US administration takes office in late January, the market will focus on early signals of policy tone and direction. Although investors responded enthusiastically to the unexpected outcome of the US election, there are still many unknowns, creating an opportunity for increased volatility.

Inflationary Pressures: We are already watchful of the pickup in inflation, albeit from a very low starting point. Recovering commodity prices, specifically for crude oil, will be a key indicator. We are also keeping an eye on the modest increase in wages, which could add to inflationary pressures. The ultimate effects of this dynamic on overall consumer sentiment and corporate profits will likely be a theme a running throughout 2017.

Growth in China: China’s economy appears to have stabilized, but at a cost of increased debt levels. In addition, the powerful forces spurring capital outflows, including corporations paying down their dollar debt, have prompted Chinese officials to tighten capital controls. It is a precarious balancing act that does not leave much margin for error.

Rising Interest Rates: The US economy continues to expand, making it likely that the Fed will increase rates more aggressively in 2017. This could lead to capital flowing out of emerging markets in Asia. Declining markets in the region could result in increased shorting opportunities; however, we believe a broad selloff in the Far East would present revenue challenges for securities lending as underlying asset values decline.

Dispersion in Corporate Earnings: Consensus is that the impressive rally in the stock market is a direct result of the historically low interest rate environment and quantitative easing (QE). As the impact of the QE program begins to fade and focus turns towards more fiscal stimulus, it is likely that we will see increased dispersion in equity valuations, causing markets to normalize. This should force corporates to show sufficient growth in order to justify – what some consider – already high equity valuations.

SECURITIES LENDING FOCUS

With capital market valuations soaring near all-time highs and increasing sentiment around potential downside volatility, we could witness an increased focus on hedging as the market becomes concerned about a potential sell-off. We believe market neutral long/short equity strategies could see a bump in demand which would ultimately drive demand for borrowed securities. Separately, the impact of geopolitical events on capital markets may lead to increased volatility and reduce pricing correlations from their historically high levels, thus creating greater dispersion and a distortion in pricing. This could then create an environment where stock selection/picking becomes increasingly important – a situation where there could be greater conviction to identify winners and losers rather than the accommodative rally we’ve experienced in recent years. The potential dampener on this outcome: If the political noise became so distracting that a risk-off environment is created and activity levels become muted until there is a better understanding of direction.

Improved hedge fund performance. Hedge fund performance reports have been less than stellar over the past number years, but these headlines don’t reflect the resiliency of the industry. Much of the performance shortfall has been attributed to specific strategies which are understandably challenged by the extraordinary market volatility, central bank intervention and geo-political events. The underlying fundamentals, however, look more robust. Increasingly, hedge funds are responding to market dynamics by adjusting business models and fee structures, while most of the recent hedge fund redemptions are being returned back into the industry as investors search for yields. We expect the need for hedge funds to improve performance and increasingly favorable conditions should be positive for borrower demand.

Quantitative strategies are likely to grow. Hedge funds around the world are expanding their quantitative teams to profit from the abundance of market data. Investors continue to allocate more capital to quant funds, which have performed relatively better than traditional long/short strategies. From a lending perspective, this means more borrowers will build out higher latency connectivity offerings, and lending demand will increase for small and mid-cap securities. Depth of inventory will be in focus as quant funds require a broader range of securities based on programmed algorithms.

The European banking sector is under pressure. Ongoing regulation and strengthening of capital ratios will place a strain on European banks. We expect a flat yield curve and a low interest rate environment to bear negatively on earnings, resulting in increased lending demand in the sector.

The global luxury goods industry may experience stagnation. Last year’s terror attacks in Europe hurt tourism in the region, but we expect a modest, gradual pickup in visitors this year. However, rising political unrest in Hong Kong could lead to fewer visitors from mainland China, triggering a decline in sales for luxury goods retailers in the region.

The offshore oil and gas sector is finally showing signs of recovery as oil prices recover from historic lows. Expectations are for prices to increase to a more sustainable level, but the industry is likely to take many more years to fully recover.

US healthcare will be an important area of focus as the Trump administration seeks to repeal parts of the Affordable Healthcare Act and increase competition in the industry. Healthcare insurers and hospitals will be among the sectors that will face greater scrutiny.

The alternative energy industry is facing uncertainty on the likely scenario that the Trump administration will seek to scale back regulations and increase drilling activity. This would keep oil prices more competitive than alternative energy, potentially placing pressure on individual companies in the sector. Additionally, federal tax incentives for the industry may be at risk under a president who has historically not been a major supporter of alternative energy.

The Chinese real estate market and overall economy remains heavily reliant on debt, which the property market is beginning to feel overvalued. There is potential for the bubble to burst, leading to increased company defaults.