Canadian in character

Rob Ferguson of CIBC Mellon offers local insights on commodity trends and their impact on Canadian securities lending

With the sixth Canadian Securities Lending Association annual conference taking place on 2 June 2016, securities lending market participants and stakeholders from Canada and across the globe will come together to take stock of the current trends, opportunities and changes facing one of the world’s largest lending markets.

Long hailed as a global safe harbour in turbulent markets, the stability and transparency of Canada’s banking and regulatory environment, along with its AAA debt rating and status as a stable and mature market, have helped Canada’s securities lending market maintain its position among the world’s largest and most active. Nonetheless, macro trends in the global and Canadian economies do mean a changing market with both challenges and opportunities for participants.

Being a resource-focused market, the Canadian economy has experienced dampened growth with the low level in energy prices and other commodities, which are well below historical averages. The per-barrel price for West Texas Intermediate has recently averaged US $38 per barrel, according to the Bank of Canada—significantly less than the US $93 per barrel average of 2014. The resulting contraction of business investment seen by the Bank of Canada in the energy sector has been a significant drag on economic activity and we are seeing more consolidation in the sector. On the other hand, securities lending activities have seen an uptick in resource-based Canadian equities and corporate bonds and thus has benefitted from this trend.

Simultaneously, we have also seen the Canadian dollar dip to lower levels. The Bank of Canada has been noticeably proactive in its commodities correction and announced on 21 January 2015 that it was lowering its target for the overnight rate by a quarter of a percentage point to 0.75 percent, which the street was not expecting. The Bank of Canada noted that it made this decision in response to Canada’s sharp decline in oil prices. Some market participants have nonetheless benefitted from interest rate cuts, particularly those who are well positioned with respect to cash reinvestment programme participation set out across longer horizons with a favourable interest rate differential. Further to that rate cut, on 15 July 2015, the Bank of Canada announced that it was lowering its target for the overnight rate by a quarter of a percentage point to 0.5 percent. The Bank of Canada cited further downgrades of business investment plans in the energy sector, as well as weaker-than-expected exports of non-energy commodities and non-commodities for the downward revision.

From a securities lending perspective, borrowers in Canada have benefitted from weaker commodity prices, specifically in companies that have exposure to the oil or resource sector. Business in Canada over the last couple of years has been heavily-weighted towards general collateral lending and in Q3 2015, with correction in commodities and specifically in energy, we’ve seen a shift towards the warm special space as many of the resource companies have come under pressure, as well as secondary markets with exposure to Western Canada or the commodities industry, such as mortgage and financing companies.

Usually with a market downturn, affected companies may choose to offer dividend reinvestment plans (DRIPs), even at a discount, to preserve cash while maintaining their dividend payment. But over the last year in Canada, we’ve noticed a different trend with affected companies eliminating their discounted DRIP offers and reducing or suspending dividends as their method to preserve cash. Given this strategy, it just shows the negative pressure that the energy sector has been under.

Uncertainty continues around whether energy producers and related firms will be able to maintain their activity levels at the current low prices. We are seeing a decrease in capital expenditure spending by the energy sectors, along with reduced exploration and product development. Meanwhile, healthier companies are looking for opportunities to purchase distressed assets and improve efficiencies. This should keep energy and resource-based securities in focus for securities lending.

Mergers and acquisitions (M&A) activity in Canada is moving at a brisk pace, given the lower Canadian dollar and opportunities to grab discounted assets. We’ve seen record M&A activity that involved Canadian companies in Q1 2016. There is demand for good quality assets for sale, including undeveloped oil reserves and physical properties. We could expect to see increased M&A activity in the energy sector as assets in companies continue to trade at a discount. This bodes well for securities lending as the steady pressure on the resource sector will likely mean continuing specials in the Canadian equity space.

In the non-energy commodity sector, lower prices are expected to add to constraints on mining activity, according to the Bank of Canada. Declines in base metals, from iron ore to zinc, have lowered the Bank of Canada’s non-energy commodity price index, which fell below the central bank’s levels that were assumed in October 2015. This trend in Canada is part of a wider global trend with excess supply of base metals. In Canada, the current excess supply of base metals suggests that prices may continue to fall modestly until either production is substantially decreased or demand picks up. In terms of securities lending, we have seen a pick-up in demand for companies relating to base metals and drilling over the past year.

In recent quarters, we have seen lower oil prices come against a backdrop of more wide-ranging growth in Canada. Outside the energy sector, we are beginning to see the economy rebound and the Bank of Canada attributed this to foreign demand, stronger exports, improved business confidence and investment, and employment growth. With the weaker Canadian dollar, we’ve been seeing the manufacturing sector bolster the economy, given that for many exporters, the exchange rate depreciation has boosted margins on sales in US dollars. This cash flow denominated in Canadian dollars allows for price competitiveness and additional funding for firms to increase their investment spending.

Overall, investment outside the resource sector is expected to strengthen. Canadian companies that are involved in the manufacturing sector have benefitted over the last few months, which has benefitted securities lending from a mark-to-market perspective. Prices of energy and other commodities remain well below historical averages, but there are some signs of improvement and stabilisation. Even with energy specials existing today, we’re seeing commodities prices rebound. It remains to be seen if the current rebounds will materialise into a bull market for the commodities space with a true correction in the marketplace.

At the end of the day, the market of course retains its fundamental ‘Canadian’ character, marked by stability, strength and a culture of prudent risk management. For that, even Canadians should be unapologetic.

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