Updates From the Equities Desk

Major equity markets, with the exception of Japan, posted positive returns in the fourth quarter.The fourth quarter was a positive quarter for equities, with the most notable exception being Japan. There was volatility as risk appetite moved depending on economic data and items such as the Euro Zone debt crisis.

2011 was a tumultuous year for equities. Having started positively with many investors anticipating continued economic recovery across the globe, markets were hit by a succession of macro issues, hurting confidence and creating uncertainty. Most markets ended the year down, some significantly (e.g., Hong Kong -20%, Japan -17%, Italy -25%, France -17%), with the U.S. bucking the trend with the S&P 500 up 2% for the year.

Activity across the equity lending book in the fourth quarter varied depending on the region, with Asia-Pacific and the U.S. being very busy, and Europe remaining relatively quiet. In Asia, short selling and lending activity were high as investors bet on falling share prices from a slowing Chinese economy. Adding to the negative sentiment was concern that the real estate markets in China and Hong Kong were overpriced and due for a correction and corporate governance and accounting fraud at several Chinese companies. Activity also picked up in Australia with retailers in high demand as that sector of the economy struggled.

In Europe, short selling and lending activity were relatively weak with investors cautious of adding risk given the continued uncertainty over the debt crisis and the lack of action from policy makers. That coupled with short-selling bans in financial stocks in France, Italy, Spain and Belgium, impacted business in what was previously the most actively traded sector. Europe was however busy with dividend trades. The last quarter, although not rivaling the main dividend season earlier in the year, did have a lot of major European companies paying dividends (e.g., Total and GDF Suez of France, ENEL of Italy, Royal Dutch Shell U.K./ Netherlands and Telefonica of Spain). Demand from borrowers was strong and levels were high, in most instances eclipsing last year and, where a company pays multiple times a year, better than previous dividend trades earlier in the year. In the U.S., short selling and lending activity were strong, continuing the momentum from the third quarter, being driven by negative sentiment about the economy. Another driver of higher lending volumes was hedge funds selling down long positions and reducing leverage. This meant prime brokers had less internal inventory to cover client shorts and therefore had to borrow more stock from the street, driving up lending balances at the agent lenders.

In terms of the sectors most in demand:

• Asia-Pacific – Demand across Asia was broad based. Chinese companies traded on the Hong Kong Exchange were in demand. As investors bet on a slowing global economy, property and construction stocks, consumer goods, mining and commodity companies, technology, gambling, retail and industrial companies were all in demand. Financial stocks were also in demand due to credit concerns, having expanded their lending significantly in recent years, leading to fears of future bad debts and write-offs.
• Europe was the weakest region this quarter in terms of activity. Financials, alternative energy (solar panel and wind turbine industries) and semi-conductor provided the bulk of our top revenue generating securities.
• In the U.S., retail, alternative energy, technology and shipping were all active and IPO activity picked up towards the end of the year, with the most notable trade being Groupon.
• Demand across the globe was primarily driven by directional trades. The fourth quarter was another weak quarter for corporate activity as market volatility made it difficult for firms to raise capital and made companies reluctant to commit to takeovers, preferring instead to hoard cash. Overall in 2011 share sales and rights offerings fell about 30% from 2010. M&A was up slightly on 2010, but well below market peak in 2007. A big MSCI rebalance in November caused a lot of volatility in the lending markets, with a lot of hard to borrow (special) stocks leaving the index. While deletions increased demand from borrowers, they also resulted in sales by our clients which in turn led to recalls.

Despite a pick up in the fourth quarter, hedge fund performance in 2011 was down on average 5%, with some well know stars of the industry suffering very poor performance. Strategies that performed well included those with a market neutral stance, some short biased managers and very actively traded equity strategies. Some hedge funds were positioned for economic growth at the start of the year, de-risking when those bets did not pay off, and then failing to buy into the equity rally towards the end of the year. Assets under management continued to grow however, reaching an all time high surpassing $2 trillion.

On the regulatory front, the European Union finally agreed on short selling rules for equities, sovereign debt and CDS. The final draft was amended based on industry feedback, but challenges still remain as the detailed wording is drafted. Korea removing their short selling ban in November provided some good news to the market. There was good demand to borrow, so balances quickly recovered back to pre-ban levels. Less good news occurred in Taiwan, where they introduced more stringent limits on the amount of stock investors can short sell, and the Government encouraged local lenders to withdraw from the market.