Given that low Base rates are here to stay for a long while yet, which assets will benefit most from the BoE’s low-rates-for-yonks policy (which is primarily directed at halting the recession and, as a consequence of growth, reducing unemployment)?

Normally government bonds sell-off (higher yields) when the market sniffs an economic recovery but with so much spare capacity in the economy to be worked through, Base rates will remain low until a recovery is well under way and unemployment has turned decisively lower.  In this environment short-dated government bonds should continue to do well, especially for those within 5 years of maturity.  Longer-dated yields may well go higher (especially once the BoE finishes spending its QE money) with the result that we may see a very steep yield curve sustained for quite some time.

Credit spreads on corporate bonds should carry on tightening, although there will come a limit when the absolute level of the coupon offered scares investors – lending money to a BBB-rated corporate at, say, 3% for 5 years will surely make investors think twice.  The margins currently enjoyed by banks will also serve to stop credit spreads from tightening too far as banks enjoy better protection on their loans (so logically the credit spread on corporate bonds ought to be greater than banks’ lending margins).  A steep yield curve also benefits banks greatly too.

Commodities follow a price path all of their own as they offer no yield, so they offer little attraction to income-seeking investors.

Which brings us to equities. Yields in excess of government bonds coupled with low Base rates until a recovery appears mean that equities could quite easily become over-valued against the current backdrop of macro policy.  Companies with big pension schemes may not join the party as the combination of tightening corporate credit spreads and bond yields being held down by QE buying will result in lower AA-bond yields (which are used as the discount rate with which pension scheme liabilities are calculated).  This will temporarily result in bigger pension scheme deficits which the market may well take fright at (again) for those companies affected (the usual suspects are British Airways, British Telecom, etc.), but the effect will subside once the BoE stops propping up the gilts market and long-dated gilts sell off (higher yields).

Once the supply of fresh equity from companies raising money to pay down debt and get their balance sheets into better shape has largely abated, the coast will be clear to bid up the price of equities.  Any type of a recovery (slow & protracted would be ideal) will result in companies growing their top-line sales revenues, whilst all the cost-cutting implemented since the credit crunch hit in summer 2007 means that lots of that top-line growth will translate into higher profits.  And high unemployment rates also mean that workers won’t be getting much of this profit growth.

The obvious risk to this all-out bullish view is that the economy double-dips badly and the hoped-for GDP growth never materialises.  Until that prospect (which looks very unlikely at the moment) seems much likelier to happen, it will not pay to be bearish on equities.  The Bank of England is too worried about spare capacity bearing down hard on inflation to care much, for the time being, about an asset bubble developing in equities.

Is there really such a thing as a global market in talent for top executives?

Whilst compensation consultancies (wonderfully dubbed “Ratchet, Ratchet & Bingo” by Warren Buffet) would have us believe that such a market exists for talented individuals and therefore Boards of Directors should benchmark their executive’s pay against global peers (strangely those “global” peers only include highly paid Western managers and not the Salarymen of Japan, nevermind the poorly paid managers in Third World countries), it seems hard to comprehend that most executives would uproot their families (and pull settled children out of schools) and move to another country.  There is also the risk from the employer’s point of view that the new foreign hire will not seamlessly blend into their new company’s culture and mix easily with the existing staff.

It is probably true that newly qualified MBA students are the most willing jobseekers to look globally for a position, but managers who have been in situ for a while are likely to have put down roots in their local communities and would be killed by their spouses for even suggesting moving their 2.2 kids and the family dog to e.g. Singapore.  As a nation, the Dutch seem to have managers who make a success of it abroad (e.g. Marc Bolland of MKS and previously MRW) whilst football managers are very well travelled (Guus Hiddink has managed successfully in many countries).  However it is arguabe that football is not strictly a proper business as it seems to be a hobby for very wealthy owners and a goldmine for talented players.  In that sense football is similar to investment banking in that the players/bankers seem to end up with all the money whilst someone else bears the losses…

Boards should stop wasting money on Ratchet, Ratchet & Bingo and use some common sense instead. These recessionary times provide the perfect opportunity to resist the ever-upward cost of executive compensation packages (the argument runs that surely each of our executives deserves to be paid upper quartile pay or we otherwise admit that, by definition, we have sub-standard managers).

Now that LLOY has wriggled free of the APS and RBS has had no option other than to enter APS, there is uncapped upside in LLOY shares whilst RBS shares still remain effectively capped at 65 pence (due to the terms of the B shares).

Both LLOY and RBS have now sufficiently strengthened their Core Tier 1 capital ratios (to 8.6% and 11.1% respectively) for the market’s focus of attention to turn to recovery possibilities.  RBS have forecast losses for each of the three years 2009, 2010 and 2011 which will eat into their Core Tier 1 capital (and 59 pence NAV) and these losses also imply that RBS will not even start to redeem their outstanding £25.5 bln B shares until 2012 (and then it will probably take RBS at least three years to fully redeem the B shares as they have to be redeemed with fully-taxed profits).  Hence RBS shares are effectively capped at 65 pence until the middle of the next decade because if RBS shares trade above 65 pence then the 7% B-share dividend falls away.  In this case HMT would logically want to convert its B-shares into ords and sell them in the market to realise a profit for the taxpayer.  But £25.5 bln B-shares convert into 51 billion ordinary shares (vs 56.35 bln currently outstanding) and ordinary shareholders will not want to get diluted in this way.  This is a real obstacle in the way of RBS shares progressing above 65 pence anytime over the next 5 years (it is also noteworthy that RBS CEO Stephen Hester’s full £9.6 mln compensation package depends on RBS shares getting to 70 pence).   The only way around the 65 pence cap is for RBS to somehow generate £25.5 bln in Core Tier 1 capital in order to be able to redeem the B shares but launching a rights issue is not the solution as this too will dilute ordinary shareholders (as would a debt-for-equity swap).  RBS may be able to make some money by buying back more of their own debt at a discount but this will only generate a small fraction of the £25.5 bln needed to clear the upside for RBS ordinary shares.  In the meantime RBS are not going bankrupt but RBS shares only become worth buying if they fall back towards their 10 pence low seen in January 2009.

Investors in RBS should switch into LLOY and take up their rights.  There will be plenty of opportunity to bank profits in LLOY and rotate back into RBS over the next 5 years.

As for the other major banks, HSBC are profitable and as a result their Core Tier 1 capital ratio is creeping higher (now 9.0%), but their 80% loan-to-deposit ratio is very conservative.  BARC have recently reported a Core Tier 1 ratio of 8.9% but they seem to be mutating into a global investment bank.  Assuming (for simplicity) the LLOY £13.5 bln rights issue is 1-for-1 at 50 pence, then LLOY post-rights NAV will be approximately 90 pence.  This gives an idea of where LLOY and RBS shares will eventually end up as over the long term bank shares seem to range between 50% and 300% of book value. 

Post Script (7 Dec 2009) : The actual terms of Lloyds’ rights issue were set at 1.34-for-1 at 37 pence.  This results in a Net Asset Value of approximately 73 pence per LLOY share after the rights issue is completed.

So two central banks have led the way and raised interest rates (Australia and Norway), starting their journey on the long way back to interest-rate normality.  But it does not necessarily follow that just because two commodity-linked countries have started to hike rates, the Fed, BoE and the ECB are about to follow suit anytime soon. Speculation that the Fed and BoE are contemplating rate hikes is way too premature – the order of events will surely be for Quantitative Easing spending to be halted first and only then will the central bankers turn to taking back some of the rate cuts they have implemented since the summer of 2007.

The US has recently reported GDP turning positive in the third quarter of this year but the US economy is still far too weak for the Fed to risk halting QE anytime soon, let alone even think about raising interest rates from their current floor of 0.25%. One positive quarter of GDP is just the start of a potential recovery  (which could easily fizzle out again next year) and the Fed made it clear in their Fomc statement earlier this week that rates are staying put “for an extended period” and the Fed won’t even finish spending its current $1.75 trillion QE money until the end of March 2010. As was announced today, US unemployment is still rising and has now reached 10.2%.

Similarly the Bank of England this week increased by £25 bln its QE target to £200 bln, to be fully spent by the end of January 2010.  The BoE will most likely decide to print even more money if GDP does not return to growth in Q4 (after the surprise of the UK posting another quarter of recession in Q3).  As the BoE will not raise rates ahead of next year’s General Election, theoretically the ECB is in line to be the first of the major Western central banks to implement a rate hike as they never embarked upon QE in the first place.  However the jury is out on whether the ECB will raise rates with Spanish unemployment of almost 20% and with Ireland looking set to go to the IMF to seek a loan.

Inflationary pressures will not be seen in the UK until a lot more of the £200 bln QE money finds its way off deposit at the BoE (where £151 bln currently sits) and out into the wider economy where it can begin to chase the price of goods & services higher.  Therefore the BoE will only come under pressure to raise rates in the near term if the Pound Sterling collapses.

So the sight of central banks raising rates looks to be spotted for the time being only in the economies of the world which export commodities.  China will probably be the first Asian central bank to increase rates because the Yuan is closely tied to the US Dollar and other Asian countries do not want to raise rates and cause their currencies to appreciate against the Dollar or the Yuan.