New Report Finds Little Chance for Quick Recovery

Despite a welcomed double-digit increase in European stock valuations since last summer, institutional commission payments to brokers on trades of European equities have sunk to their lowest level since 2010. A new report, European Equity Bull Market Not Enough to Mend Buy-Side/Sell-Side Relationship,  from Greenwich Associates concludes that the prolonged slowdown in trading activity is straining relationships between institutional investors and their brokers.

After peaking at €4.2 billion in 2009, annual European equity commissions paid by the institutional participants in Greenwich Associates research have dropped 28% to €3.01 billion. “We should all just go on holiday,” one brokerage executive told Greenwich Associates, lamenting the past year’s depressed turnover.

Although the lull in trading activity has hit the sell side hardest, the buy side is feeling the reverberations. As a result, each side increasingly feels short-changed and has responded accordingly:

• Brokers have reduced service levels to less profitable customers. In 2008 the typical institution paid approximately $15.5 million per year in commissions on trades of European equities; that amount plunged to just $9.04 million in 2013. At the same time, new capital rules and other bank regulations have shrunk margins on most capital markets businesses. During the worst of the European sovereign debt crisis, many top brokerage firms resisted the impulse to shrink their businesses significantly in the expectation that investors would return to prior “normal” levels of activity once the crisis abated.
  
  The crisis did fade, opening the door to the current rally in European equity markets. A recovery to “normal” trading activity, however, never came to fruition. Over the past 18 months, many major brokers finally capitulated. Accepting that trading volumes would remain at suppressed levels for the foreseeable future, they moved to reduce costs — in cases dramatically. “When it comes to equity trading revenues, brokers are planning for the worst and hoping for better,” says Greenwich Associates consultant Jay Bennett. “Nobody is even hoping for the best anymore.”
   
• Frustrated institutional investors have responded by cutting broker lists at the tail and concentrating business with top brokers. Buy-side firms are frustrated at what they see as deterioration in the service and coverage quality they are receiving from their brokers. One of the biggest problems: turnover. With brokers cutting staff and reorganizing desks to save money, institutional coverage and relationships have been disrupted.
  
  One buy-side equity trading professional coined the term “juniorization” to describe how some sell-side firms have laid off veterans and replaced them with younger, less experienced and cheaper talent. “Institutions sometimes feel like they have to educate the research sales pros and sales traders covering their accounts,” says Greenwich Associates consultant John Colon. “That’s a big change from the past when investors relied on their sell-side contacts for market expertise.”

Catalysts for Reconciliation on the Horizon?
Recent hopes for a resurgence in trading activity have centered on the much-anticipated “Great Rotation” — the presumption that an inevitable upward turn in interest rates will trigger a flood of investor assets out of fixed income and into equities. Global markets expect the U.S. Federal Reserve Bank to begin winding down its quantitative easing in September 2013. The mere hint of such action sent U.S. Treasury rates flying in late June and led to record outflows from fixed-income funds.

Rather than shifting money into equities, however, many gun-shy U.S. investors have parked their assets in low-yielding money market funds. Meanwhile, equity trading volumes in U.S. stocks remain at historically low levels. These facts suggest that a near-term surge in trading activity is unlikely in Europe, where economic momentum has trailed that of the United States.

Furthermore, Greenwich Associates research (2012) shows that institutional funds in the United Kingdom expect to significantly reduce allocations to European stocks in the next three years and funds on the Continent plan to hold existing, and relatively small, allocations steady. Even if interest rates finally rise to a point that triggers investor allocation shifts to equities, it by no means ensures a boost in European equity trading activity. Historically, trading volumes have increased most in volatile markets — not strong markets.

As a result of these combined trends, most major brokers have given up hoping for a quick cyclical rebound, and many investors seem to agree: A 45% plurality of the institutions participating in the Greenwich Associates 2013 European Equity Investors Study do not believe the European equity market will return to pre-crisis turnover levels by 2014. “The answer to the question ‘is there any relief in sight’ is simply ‘no,’” says Greenwich Associates consultant Jay Bennett.