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The cost of living has been on everybody’s mind. But won’t anyone spare a thought for the cost of leverage?
It’s going up, says Société Générale (with our emphasis):
The cost of funding synthetic (i.e. leveraged) exposure to large cap equities has risen to all-time highs (exemplified by the US, but also seen across Europe and other equity markets). While regulation-led constraints on balance sheet usage have been a persistent feature since 2013 (post Basel III implementation) and continue to impose constraints to this day, most of this rise in funding cost can be explained by the imbalance between this limited supply and growing demand rising from the spectacular rise in equities over the past two years. End-of-year effects have likely worsened the problem.
The specific “funding” here is happening in equity repo markets, more commonly known as securities lending.
That’s interesting, because when securities-lending costs rise, it’s usually for the bearish investors who are borrowing stocks to sell short. But short selling seems to be going out of style, regrettably, or at least concealing itself more. So when SocGen discusses rising equity funding costs, it means the cost of levered bets that stocks will rise:
US stocks have climbed a lot already — two consecutive annual gains of more than 20 per cent in the S&P 500 — and investors are crowded into long positions, which is part of what’s making this exposure so pricey:
The only thing that could relieve some of this pressure is a correction in stocks, writes SocGen strategist Jitesh Kumar:
Will the funding stress subside? A correction in equity markets would be a natural recipe for the reduction in demand. The extremely high cost of funding in the US is just the entry cost for access to the exceptionalism of the US corporate sector and may remain high if US equities continue to outperform.
America! Still, it’s a broader story than just “line goes up”. Other corners of funding markets have been showing signs of strain as well, says SocGen. This tends to happen ahead of the end of the year, when banks tidy up their balance sheets, Kumar writes. But there’s also lots of supply of Treasuries (and other sovereign debt) to go around:
The markets have also seen very high levels of volatility in swap spreads (the difference between the fixed rate in a swap and the yield of a Treasury security of the same maturity). An increasing supply of sovereign collateral has arguably led to higher repo vs benchmark swap rates and tighter swap spreads, but there have been other contributing factors such as the US election and idiosyncratic investor activity.
Whatever the cause, there’s been a noticeable pickup in repo activity for both Treasuries and equities, the bank finds:
And while Treasuries remain, by far, the biggest collateral pool for repo trades — they’re “general collateral,” after all — what’s most notable is how quickly the use of equity repo has grown:
And it’s happened without any real loosening of the regulatory constraints on dealers’ balance sheets. Here’s another view of the growth in equity-repo financing, this time among primary dealers:
So what’s driving the growth in demand for equity repo leverage?
Well, the most obvious answer is that nobody wants to miss a stock-market rally.
SocGen also hints that the proliferation of total-return futures, which (unlike swaps) are listed and centrally cleared, could be a factor. The rise of leveraged ETFs could be contributing as well, Kumar says:
And until that correction comes about, the best bet for institutional investors is to be on the other side of the trade (“offering balance sheet capacity”), says SocGen:
Investors with unlevered and flexible balance sheets can pick up some extra yield above benchmark rates by offering their balance sheet capacity. Equity forwards are also trading at expensive levels given high levels of cost of funding, making downside hedges cheap. We recommend that investors remain invested and hedged.
If they’re lucky enough to own stocks outright, that is.
