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Fed Cut Rates – But Grave Risks on Growth Remain: ICYMI

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The market got what it wanted out of the Federal Reserve – and stocks still took a pounding.

The central bank cut its benchmark lending rate half a percentage point, to a range of 1% to 1.25%. The coronavirus continues to keep manufacturing plants in China and Europe shut, threatening global and U.S. supply chains and keeping consumers home.

Stock investors had wanted a rate cut as China’s economic growth was curtailed and many saw U.S. 2020 growth likely to fall short of the current estimate around 2%.

Still, all three major U.S. stock indexes fell considerably Tuesday. The S&P 500 fell 3.21%.

Investors bought up treasury bonds, with the 10-year . That yield and the two-year treasury yield are both below the federal funds rate. That’s an abnormality just after a rate cut, and it signifies how nervous investors are that a recession might soon set in.

Why did the Fed cut rates and why did stocks still fall?

The Fed wanted to get out in front of a potential economic shock to the U.S. And a senior investment strategist at UBS, Leslie Falconio, told TheStreet that the Fed wanted to loosen financial conditions.

After last week’s selloff, sending stocks to 14% off their all-time highs, credit spreads over treasury yields widened, as high-yield bonds sold off. Bonds rated BBB, for example, now yield about 1.5 percentage points more than BB bonds do, compared to the beginning of 2020. The Fed wants borrowing costs to fall from here.

And while most agree that lower rates can’t get consumers who are nervous about the virus to leave their homes and head for the mall or get companies to start manufacturing again, the added liquidity could make the hoped-for second-half global economic recovery even stronger, CLS Chief Investment Officer Mark Pfeffer told TheStreet.

"Now that the benchmark federal funds rate target is 1% to 1.25%, it must be noted that the Fed’s most reliable ammunition,” lower rates, is “dwindling," Bankrate Senior Economist Mark Hamrick said in emailed remarks.

"The other challenge involves how the Fed may take back the rate cuts once the outbreak and economic damage is behind,” Pfeffer wrote. "What happens when the coast is clear and growth starts to resume?” Pfeffer asked. “Are they going to take back 50 basis points?”

If the virus is bad enough that U.S. companies run out of inventory and cannot import enough from China, the economy may head into recession. In that case, the Fed is more likely to cut rates a few more times. If no recession ensues near term, the Fed may lift rates back to their prior levels.

Stocks did fall, as investors view the Fed's haste as a sign the central bank is particularly worried about economic growth. 

Through all this, stocks, especially in the economically favorable U.S., remain attractive, many strategists say.

"Long term, U.S. stocks are going to be the only game in town,” Pfeffer said. “You’ll get a higher yield on the stock market than on long bonds.”

While the average forward earnings multiple on the S&P 500 of 16.9 times is higher than the 10-year average of 15 times, it’s still a bit low compared with interest rates.

Twelve-month forward earnings estimates expected for the S&P will fall from an average around $178. They already have fallen for semiconductor companies.

But the risk premium investors demand for holding stocks rather than treasuries will still be higher than 4.5% when and if rates rise a bit from here. Historically, that premium sits at around 3% or lower. If that’s any indication of the future, stocks are likely to rise from here.

Unless we are truly about to enter a recession. 

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