As we approach the end of the first quarter, there is no doubt that the weak demand environment for equity borrowing which characterized the majority of last year has extended into 2017. Equity loan volumes in March were down 8.5% on the same period in 2016 with average loan fees down even further by 23%.* However, as Keith Haberlin, Head of BBH Global Securities Lending, explains, there are reasons to suggest that the underlying causes of the subdued demand environment thus far in 2017 are different than those in previous years and more temporary in nature.
The Impact of Monetary Policy on Demand
By now it is well accepted that the unprecedented monetary policy unleashed on the market between 2009 and 2015 created a very challenging environment for stock pickers and curtailed borrowing demand as a result. With so much money in the system propping up equity valuations, hedge funds that placed bets on individual stocks saw much of their fundamental analysis rendered futile in the face of an indiscriminate rally. With the resulting negative impact on performance and a backdrop of clients leaving for better performing and lower cost strategies, it is not surprising that short conviction suffered or that lower cost tools such as ETF’s were used to get short exposure.
Uncertainty Pervades as Monetary Stimulus Makes Way for Proposed Fiscal Stimulus
But with the Fed both tapering stimulus and increasing interest rates, correlations between stocks listed on the S&P 500 declined since the 2016 election to their lowest level since 2000.** With dispersion between stock prices increasing, a much more favorable environment for stock pickers seemed imminent, until that was, the shock result of a Trump administration. While many of the new administration’s policies are expected to create opportunities for hedge funds, what we have witnessed since November is another broad based rally, fueled this time not by monetary stimulus, but by fiscal stimulus — or at least the promise of it. Just how many of the new administration’s tax, trade, deregulation and spending policies will come to fruition remains to be seen, but amidst the uncertainty, hedge funds have seemingly been happy to ride the rally and get some early performance on the board. Nobody wants a replay of Q1 2016 when some early bad calls put funds in a performance hole they spent the rest of the year digging themselves out of.
When the Political Fog Clears
With all that said, the signs remain that events could change quickly. While the Healthcare Bill is taking center stage right now, the new administration will shortly turn their attention to new bills on tax, financial regulation and trade. These are expected to incentivize US corporates, among other things, to repatriate offshore profits, some of which will be used to fund acquisitions. A protectionist policy on trade, including a proposed border adjustment tax, will impact companies both in the US and overseas that rely heavily on a complex global supply chain. Pharma, healthcare providers and alternative energy are among other sectors that could all come under pressure if campaign policies turn into concrete legislation. In summary, when the political agenda shakes out, there should be clear winners and losers and without monetary stimulus distorting prices, active managers on both on the long and short side will be empowered to act with conviction on their analysis. The billion dollar question for the industry is how long it will take the administration to pass these bills and remove the uncertainty which is hampering the market.
Patience is a Virtue
In the meantime, we believe it is important for securities lenders to stay the course and resist the temptation to chase returns during a cyclical trough for demand. While additional return can be generated by taking on additional cash reinvestment risk or by taking lower quality non-cash collateral, these should be considered carefully given past credit and liquidity events. Our focus at BBH is ensuring we are maximizing opportunities to generate more return with a lower risk profile by expanding our product, investing in technology and engaging with our clients. These include voluntary corporate action opportunities, particularly in a Europe still focused on capital raising, entering new markets and mobilizing assets held back from lending.
*Source: DataLend, March 2017
** Source: Goldman Sachs Global Investment Research, February, 2017