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.