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Credit Suisse has the answer.

In a prescient note published today (before the Bank of England’s record rate decision, it seems) they observe the following:

The market is currently expecting UK rates to fall by 75bp at 12.00 today and European rates to fall by 50bp. We believe that into a credit crisis, real rates need to be zero for a long period (this happened in the US for 2 1/2 years between 2001 and 2003 and for nearly 2 years between 1992 and 1993- these were both minor deleveraging crises). A zero real rate in Europe would probably require 1 1/2% interest rates in both the UK and Europe. Markets now pricing in a low in UK rates of 2.4% in June and in the ECB policy rate of 2.4% in September - there is not a lot of downside.

Cyclicals, especially consumer, which normally perform well are out of the question this time around, the bank argues, because:

• it is the direction of bonds yields that determines the performance of cyclicals not the yield curve - and we believe that bonds yields are still heading lower.

• cyclicals are not yet at recession level discounts to defensives on P/B relatives, nor do they look cheap on HOLT.

• deleveraging reduces the effectiveness of monetary policy on growth, especially in the UK.
  

Instead, the analysts propose playing lower rates via a weaker Sterling (down to about $1.6011 since the BoE’s announcement):Our simple view for the past 18 months has been that the best way to play falling UK rates is via a weaker sterling. Fair value on PPP is 0.85 Euro/£ and on sterling/dollar long term PPP is 1.53- historically sterling was troughed around 10% to 15% below fair value on the dollar. So long term (2010) we can see sterling going to $/£ 1.30. On our screens, the stocks with the highest overseas exposure that look cheap on HOLT and on P/E relatives are: AstraZeneca, Meggit, Ashtead Group, Bba Aviation, Cookson, Bodycote. Of these we would particularly highlight the non-cyclical play: AstraZeneca. For the cyclical bulls the most obvious beneficiaries are those with transactional exposure (ARM, Rolls Royce).

We would rather buy the credit related areas than consumer cyclicals. It is clear that economies can’t start to recover until credit spreads fall and credit markets function. Credit typically leads equity at major turning points by up to a quarter. The valuation case for credit is far clearer cut than for equities (the implied default rate is 52% compared to a peak default rate of 32% back in 1932). Our preferred credit plays are:
a) insurance (both life and non-life- RSA, Aviva, Aegon, ZFS);
b) highly leveraged companies with high FCF and relative non-cyclicality (this gives us a bias towards telecom companies)- examples of these companies are: DT (Credit Suisse Outperform rated).

More perplexingly, however, the analysts are also recommending a few banks:

Banks have historically outperformed when rates fall (as it reduces the opportunity cost of holding non-performing loans), the yield curve steepens (to be more than 100bp) and credit spreads fall (they are the third best performing sector when spreads fall!). But this time around the dominant issue is the provisioning for non-performing loans as the economy turns down. Thus we would only be buying banks where:
a) their leverage and loan-to-deposit ratios are low
b) customer leverage and financial product penetration are low

This would highlight on our screens: KBC, Intesa and NBG. We would tentatively add BNP to this list (although its loan deposit ratio is a bit too high, in our view).

And in terms of countries:

4) Countries most leveraged to lower rates are clearly those where the highest proportion of debt is short term and leverage is the highest: which is, of course, Ireland (70% of mortgage debt is floating), Spain (75% of mortgage debt is floating). We still believe that the true scale of the problem in Ireland and Spain has not been appreciated and expect eventually their bond spread to rise to 200bp.

The least leveraged countries where the highest proportion of mortgage debt is fixed are France (86%) and Germany (the majority is fixed) - indeed the Bundesbank used to claim that falling short rates reduced consumption (with the German consumer being a net floating rate creditor).

If we had to choose a domestic UK sector to play falling rates, we would do so via the UK banks: RBOS (they are on 1.2x tangible book even assuming a 35% decline in house prices, 250bp of commercial real estate provisioning and 10% unsecured write-offs).

Of course, that’s if you want to “play” at all.
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