From the Lending Desks: Equities

The fourth quarter was up and down for equity markets. Early in the quarter markets were off to a strong start as weak U.S. job data increased speculation that the Fed would start a new round of quantitative easing (or “QE2”), and the view that other countries such as the U.K. would follow in an effort to bolster faltering economic recoveries. However, as often appears to be the case, as markets start to rally and sentiment improves, events occurred that resulted in risk positions being quickly taken off the table. The fragile and generally nervous state of financial markets amplifies this. At the end of October there was a tightening of interest rates by China in an attempt to slow credit growth and mortgage foreclosure litigation in the U.S. Of course the expected QE2 did materialize in November and was positive for equity prices. However, QE2 was not viewed as a great idea by everyone, especially emerging market countries who voiced concerns that hot money, seeking higher yielding assets, would flow into them, negatively affecting foreign exchange rates and inflation. Several countries (e.g., China, Brazil, etc.) took steps to curb inflows. In late November a combination of policy tightening in China, fears over euro-zone debt (as the ECB pressed Ireland to accept a bailout), an insider trading investigation in the U.S. and doubts about whether the U.S. Fed’s quantitative easing would reinvigorate the economy, put equities under pressure again. Finally we finished the quarter and the year with a December equity market rally as the U.S. approved an extension of Bush era tax cuts and economic data started to improve, sending equities to their highest levels since the collapse of Lehman Brothers in September 2008. Investor optimism about the global economy has lead to big inflows of money in equity funds, despite ongoing concern about the euro debt crisis.

In terms of sector demand for securities lending, financial, technology (semiconductor), consumer discretionary and industrial (engineering and construction, electronics) were the most heavily shorted sectors.

The main drivers of demand continued to be capital-raising and directional, plus dividend yield enhancement trades. However, borrowers continue to cover a significant portion of shorts from internal inventory, reducing the need to go to the street.

Capital-raising activity was strong again this quarter, helping drive demand to borrow shares, particularly in the financial sector with firms such as China Construction Bank and BBVA, all looking to bolster their balance sheets. For the whole of 2010 share sales were up 20% on 2009 as equity markets recovered and investors looked to put money to work.

2010 was a record year for IPO’s, with stock offerings expected to exceed $300 billion. Asian companies dominated with over 60% of the volume and the U.S. lagged Europe. A quarter of the activity was concentrated in just three companies — GM, Agricultural Bank of China and AIA Grp. The first two were significant trades from a securities lending perspective.

Hedge fund performance in 2010 barely kept pace with markets, rising on average 7% to 8%. Of course there was significant variance between individual funds and strategies. Some of the best performing strategies were in fixed income rather than equities, although this does include convertible bond arbitrage which generates demand for equities to short as a hedge.

Asia-Pacific

In November, North Korea fired on its Southern neighbor, leading to concerns of an escalation of the conflict between the two countries and causing global equity markets to fall. There was no noticeable increase in borrowing demand for Korean equities, but we did keep high buffers in this market, maintaining liquidity to cover any client selling activity. The fourth quarter continued to be an active quarter for capital raising. Across all of 2010, Chinese stock exchanges (including Hong Kong) have raised almost triple the amount of money through IPO’s that the U.S. has raised. Certainly Asia has been the growth story for securities lending in 2010 with significant balance increases in Hong Kong, Korea and Taiwan. Standard Chartered announced a rights issue to bolster capital. The Hong Kong listing was in demand from borrowers, unlike the U.K. listing, which is very liquid. AIG of the U.S. raised $17.8 billion by selling 49% of its Asian unit AIA, making it the largest Hong Kong IPO, beating last quarter’s capital raising by China’s ICBC. Continued capitalraising amongst Chinese banks (e.g., China Construction Bank and Bank of China) created lending opportunities, as they looked to strengthened balance sheets after a record lending spree. Hong Kong has been one of the hottest stock lending markets in recent months, but in October trades started to come off as the underlying market rallied, squeezing the shorts and leading to a greater long bias amongst investors. Fees on high revenue generating stocks like BYD came down as borrowers refinanced off the back of lower demand. There was some scrip dividend trading in Hong Kong as we lent shares for clients that elected the cash option in HSBC, NWS, Espirit and New World Development. In Japan, Resona was in the news after a proposed share issue to raise money to pay back the government. The stock price fell heavily driving up loan fees. Reports that the Japanese government was not happy with the share price fall, and in general about trading activity around capital-raisings, resulted in a review of short selling rules. Japanese balances came down significantly after the September dividend record date, but grew again for end of year dividends (although not to the same extent). In Australia BHP Billiton called off its takeover bid for Potash of Canada, after the Canadian government refused to approve the deal. M&A activity in Australia had reached a record in Q3 as the economy continued to grow off the back of a commodities boom, giving companies the confidence to do deals. Although it hasn’t all been plain sailing with some deals breaking down or facing opposition (e.g., Singapore Exchange Ltd offer for ASX Ltd which is facing government opposition). All this activity was of course positive for equity lending with borrowing demand in the following deals: Leighton Holdings off the back of the ACS Actividades de Construction and Hochtief deal, Kingsgate Minerals/Dominion Mining, Equinox Minerals/Citadel Resource Grp, AMP/Axa, etc. Top revenue generating securities for the quarter included BYD Co of Hong Kong; Seoul Semiconductor, Hynix Semiconductor and LG Innotek of Korea; Resona Holdings and Sawai Pharm of Japan; OCBC and Neptune Orient Lines of Singapore; and ACER, Media Tek and HTC of Taiwan. APAC markets finished the year mixed. Hong Kong, Taiwan and Korea were all up (5.3%, 9.5%, 21%). Whereas Australia and Japan were both down (2.5%, 3%).

Europe, Middle East & Africa

Concern grew again about the financial health of peripheral European countries, with borrowing costs in both Ireland and Portugal increasing, creating nervousness in markets across the region. At the end of November, Ireland agreed to take financial aid, although the sense of relief was short-lived as this sparked a political crisis in the country and led to continued speculation about contagion to Portugal and Spain. Demand to borrow Portuguese and Spanish financials (e.g., Banco Sabadell, Bankinter and Banco Valencia of Spain, and Bco Comercial Portuguese, Bco Espirito Santo and Bco BPI of Portugal) increased, whereas Irish financials cannot be shorted. Banco Popular in Spain was also in demand off the back of its capital-raising and BBVA announced a rights issue to bolster its balance sheet and to fund a stake in Garanti Bank of Turkey. The ACS Actividades de Construccion y Servicios takeover bid for Hochtief which we mentioned in last quarter’s newsletter was rejected by Hochtief but approved by the German regulator. Borrower interest remained strong in ACS which became one of our top earning securities. Interest in Commerzbank eased as the bank reiterated it will not pursue a share sale; speculation about a rights issue had been driving demand. HSBC pulled out of its bid to purchase the South Africa’s Nedbank Group from Old Mutual. There was some borrower demand for Nedbank when the deal was originally announced, but it eased soon after. In the U.K. the Betfair IPO was in demand as were shares in Lonrho and Rockhopper Exploration off the back of capitalraisings. Other securities in demand due to capitalraisings included Nystar of Belgium, Gestevsion Telecion of Spain and Hexagon of Sweden. The fourth quarter was an active quarter for yield enhancement business. France, Italy, Netherlands and Spain were all very active. The main names in France were Total, GDF Suez and Pernod Ricard; in Italy they were ENEL, Atlantia and SNAM; in the Netherlands they were Royal Dutch and Arcelor Mittal; and in Spain BBVA, Telefonica and Inditex. Also in Portugal, Portugal Telecom announced a special dividend which we traded in December. Demand and levels were good in all markets. We also had some good news going into 2011 with Infineon announcing it will pay its first dividend in 10 years and Siemens announcing a significant increase to its January dividend (both German companies). We lent the January German dividend names which mainly consist of Siemens and Thyssen. Levels were higher than the previous year. November was also a big U.K. scrip month with HSBC, Cable and Wireless and Royal Dutch Shell being the main trades. Top revenue generating securities for the quarter included Aixtron, SMA Solar Technology, Solar World and Commerzbank of Germany, ACS Actividades De Construccion and Bco Sabadell of Spain, British Airways of the U.K., and Hexagon of Sweden.

Americas

The U.S. equity market had its best December in nearly 20 years and had a strong 2010 with the S&P up 15.1% and the Dow up 14.1%. From a lending perspective, sectors driving demand included retail, education, alternative energy and auto. However, balances fell into December as borrowers pared back positions over year end. This was reflected in a fall in short selling on both the NYSE and Nasdaq Stock Markets in December. The biggest news of the quarter was GM launching the world’s largest IPO in November at $23.5 billion which generated good borrowing demand and high fees as brokers needed to make good on settlement obligations. However fees fell quickly over the next few days, eventually as low as general collateral (GC) in early December. Another IPO of note was Youku.com which had the largest first day gain of any IPO in 5 years (167%). In general IPO activity started to pick up towards the end of the year, which is hopefully a positive sign for 2011. Other trades of interest included Diamond Offshore Drilling, where fees increased in October as supply tightened around its dividend record date; Valeant Pharmaceutical ADR, which declared a special cash dividend related to its merger with Biovail; and Tata Motors ADR, which saw a sharp increase in demand, coinciding with an early redemption of bonds that were trading at a significant premium. Brokers were buying the bonds and shorting the ADRs in significant volume. Also The Great Atlantic & Pacific Tea Company, one of our highest revenue generating positions, filed for bankruptcy. The resultant drop in the share price significantly reduced revenue. The top earning securities for the quarter included Sears Holdings, Veeco, First Solar, Strayer Education, Power-One and Rackspace Hosting.

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