From the Equities Desk

Equities

Equity markets ended the quarter higher, with the U.S. S&P 500 being a notable exception. Improving economic data, especially out of China and the U.S., the continued easing of the Euro debt crisis, and central bank stimulus measures were all positive factors for equity markets. The U.S. S&P faced headwinds on concern over company earnings, uncertainty about the U.S. presidential election and the Fiscal Cliff. At the other end of the spectrum, Japan was one of the best performing markets as the incoming Government pledged to press the Bank of Japan to provide additional stimulus to the economy and bring down the value of the yen.

Equity markets made decent gains in 2012 with the U.S. S&P 500 +13%, Japan +23%, Hong Kong +23%, U.K. +6%, France +15%, Germany +29%. Stimulus measures by central banks around the globe, improving economic data and ECB action to contain the EU debt crisis drove demand for shares (risk-on environment).

Rallying equity markets led to short covering by hedge funds, which in turn led to a decrease in loan balances, particularly in the U.S. and Hong Kong, which have been two of the best performing lending markets of 2012. Hedge funds have been closing short positions against the U.S. and Chinese economies, and instead adding to long positions (to capture the upside from rallying markets). Borrowers actively refinanced positions (negotiated fees lower) as demand decreased and supply increased (as loans were returned). Lending activity continued to be driven by directional trades, with investors expressing a negative view on a stock or a sector.

There was a continued decline in both the number and value of M&A deals, with the lowest number of deals since 2009.

European dividend activity was steady over the quarter with France, Italy and Spain producing the biggest revenue generating stocks (e.g., Ferrovial of Spain, SNAM of Italy and Total of France).

We also saw strong borrower interest in 2013 dividends and towards the end of the year committed to lend some of that inventory. Outside of Europe, balances increased in Japan and South Korea over the end of the year as borrowers swapped out of expensive dividend, locally held shares and into cheaper offshore stock. Additionally, the IOC trade of Vale in Brazil was a big revenue generator.

Across the lending book, sectors in demand included:

• Asia-Pacific: Consumer cyclical, industrial, financial; then a big drop to basic materials, consumer non-cyclical, communications, technology.
• Europe, Middle East and Africa: Consumer non-cyclical, industrial; then a drop to consumer cyclical, communications, basic materials, financial.
• Americas: Consumer non-cyclical; then a big drop to consumer cyclical, financial; then a drop to communications, technology, industrial.

New European short selling regulations came into force in November, including new buy-in and fail penalty rules.

The new regulation includes rules on disclosure of short positions (including public disclosure), restrictions on uncovered short sales, buy-in procedures and additional regulatory restrictions in times of market stress. Implementation went smoothly, although we did see a pick up in borrowing activity as brokers made greater efforts to cover fails.

At J.P. Morgan, we added to our collateral flexibility in the fourth quarter. U.K. sterling cash for our U.K. equity lending book and JGB Governments bonds for our APAC lending book. We expect these additions to help defend and grow business for our clients.

Looking Ahead

We expect more of same in the first quarter of 2013, with low appetite amongst hedge funds to add to short positions. Should the economic and market environment continue to improve, there's an expectation that corporate activity will increase, resulting in more lending opportunities. However, as we enter a new year, continued uncertainty about the U.S. debt ceiling is probably the biggest threat to financial markets and the global economy.

We expect a volatile European dividend season, with concerns about perceived tax risk and the ability of end users to fund their trades hitting demand. There's currently no significant changes expected in terms of tax treaties or rulings intended to drive tax harmonization, both of which negatively impact supply and lending revenue. We have however seen a few companies cancel 2013 dividends (e.g., ThyssenKrupp of Germany, Telefonica of Spain and KPN of the Netherlands).