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High anxiety

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      By Bill Hackney, Atlanta Capital Management

      Atlanta — How is your mood lately? Despite rising incomes, low unemployment, falling poverty rates, and one of the greatest bull markets in history, there is increasing evidence that many of us are ... well, going bonkers.

      Last summer, Barnes and Noble reported a 25% surge in sales of books about anxiety. Nothing more relaxing than reading a book about anxiety at the beach, I suppose. According to the World Health Organization, about 300 million people worldwide suffer from anxiety disorder. Here in the U.S., 40 million adults, about one in five of us, suffer from this malady.

      Despite being one of the wealthiest and safest countries on earth, the U.S., with 4% of the world's population, accounts for 13% of global anxiety disorders. And the diagnosis of and prescriptions for anxiety disorders are on a steep rise. The American Psychiatric Association reports 39% of Americans said they were more anxious last year than the year before.

      The WHO study found there wasn't much difference between rich and poor nations when it came to the prevalence of depression, but there was a difference when it came to anxiety. Rich nations tended to be more anxious than poor ones, with the U.S. leading the way. Researchers have linked increased anxiety to the pursuit of money, looks and social status (stereotypically American pursuits) as well as to increased loneliness and use of social media.

      Fortunately, there is a wide variety of prescription drugs to treat anxiety. It is estimated that one in six Americans takes some kind of psychiatric drug — mostly antidepressants. But America's psychological problems are more serious than just anxiety. Deaths of despair — suicide, drug overdoses and liver cirrhosis — are tragically on the increase in the U.S.

      Nobel Prize winning Economist Angus Deaton and his wife Princeton professor Anne Case made news a few years ago when they reported mortality rates among white, working-class Americans are going up in contrast to other demographic groups. Said Deaton, "You can find episodes like the flu epidemic or wartimes when mortality rates go up, but sustained increases in mortality for any major group in society are really quite rare. It's an indication that something is very wrong."

      Building on the work of Case and Deaton, the University of Chicago published last month, "Men without Work: Why are They So Unhappy in the U.S. Compared to Other Places?" The key finding: "Prime-aged males out of the labor force in the U.S. are the least hopeful and most stressed and angry compared to the same group in other regions, including the Middle East."

      What's driving all this anxiety, deaths of despair and disaffected workforce dropouts? Probably the usual suspects. Dislocations caused by globalization -- pressure on wages, jobs lost due to plant relocations. Concerns about immigration. Declining trust in bedrock American institutions -- education, media, religion, government and capitalism. Cultural factors like loneliness and addiction to social media.

      I am not a psychologist, but I do know that psychology can have a major impact on the capital markets, causing them to "overshoot" both on the upside and the downside. What's more, the fragile psyche of the American electorate — and the electorates of many countries — does impact politics and government policy. In the near-term, our nation's declining psychological health is unlikely to have much effect on the markets: Our economy is strong, monetary policy is accommodative and our collective mental condition is a somewhat nebulous force that is slow moving and difficult to measure. Longer term, say 2020 and beyond, I believe America's mental state could threaten the markets and the economy.

      First, let's look at near-term economic and stock market conditions. Here the news is decidedly more upbeat. In March the bull market in stocks turned ten years old and it is not yet showing many of the late-cycle behaviors (troublesome inflation and weakening labor markets) which typically signal the end is nigh.

      Exhibit 1 shows my five stock market indicators at the end of the first quarter of 2019 (S&P 500, 2834) compared with the end of the third quarter of 2018 (S&P 500, 2914). Of course, between these two periods, there was a massive stock market correction followed by an impressive rebound. Closing prices for the respective quarters, however, were within 3% of each other.

      Exhibit 1: Our indicators suggest the US stock market still has modest upside potential.

      Blog Image Hackney April19 Ex 1

      Sources: Bureau of Labor Statistics, Bloomberg, The Conference Board, Atlanta Capital.



      Note what has changed over the past six months. Valuations have improved. The market's price/earnings ratio dropped by about 3X, thanks to robust earnings growth due in part to the 2017 tax act (put into effect in 2018). The economy has gotten a little weaker. The trend in the U.S. leading economic index flatlined over the last five months following a protracted period of strength. Not surprising given the sharp slowdown in the global economy in recent months.

      None of my indicators are negative, but three are flashing a cautious yellow. The yield curve is very flat and has remained so for several months. (See Exhibit 2.) A brief inversion occurred in March but did not persist. I would be more concerned about this indicator if it were confirmed by a sustained rise in credit spreads, which, so far, has not occurred.

      Exhibit 2: Mind the Gaps! The gaps between short and long-term interest rates and low and high quality bonds provide important signals for equity investors.

      Blog Image Hackney April19 Ex 2

      90-Day Treasury Bill Yield and 10-Year Treasury Note Yield based on Bloomberg data. High Yield (Junk) Bond Yield based on ICE BofA ML® US High Yield Index. Sources: Bloomberg, ICE® BofA ML® US High Yield Index, Atlanta Capital as of 3/31/19.



      Wage inflation continues to creep higher but is below the 4.0% threshold which would set off a bigger inflation alarm. Given the recent favorable economic news from the U.S. and China, the Leading Economic Index seems unlikely to turn sharply lower anytime soon. If it did, a recession could be eight to 21 months away based on the history of this index.

      The remaining months of 2019 are likely to be a benign, but unexciting environment for equity investors and a tricky one for bond investors. Inflation pressures from rising energy prices and tight labor markets should push longer-dated fixed income yields higher and keep the yield curve from inverting. Higher inflation will also keep price/earnings ratios from expanding. Global economic growth will remain sluggish as will corporate earnings. In an environment of no price-to-earnings (P/E) expansion and maybe 5% earnings growth, I can see the potential for the S&P 500® to hit 2975 this year (17.5 times $170 in earnings).

      While the Trump Administration may pull the proverbial "rabbit out of the hat" with a China trade deal later this year, American business could face new uncertainties of higher taxes and tighter regulations if there is a significant change of leadership in Washington following the 2020 elections.

      Here are three key issues that give me high anxiety as we approach 2020.

      A major change in tax policy with unintended consequences. Anti-capitalist sentiment in the U.S. is high. In an effort to "punish the rich," the U.S. could implement tax policies that could wreck the stock market. Can the rich afford to pay more in taxes? Of course, they can. It's clear to virtually everyone that a return of the Democrats to the White House will result in higher taxes of some sort. But it is important to consider what types of income or property should be taxed. Higher taxes on dividends and capital gains are often discussed because stocks are perceived to be owned primarily by the rich. Tax stocks and you avoid hitting the little guy, so the reasoning goes. However, taxable individuals and corporations make up a massive amount of ownership of U.S. equities. A tax scheme aimed at the equity market will depress stock prices and hurt non-tax paying equity owners as well. What about underfunded state and local pension funds? These funds and most other pension funds have 60% to 70% of their assets in stocks and equity-like investments (private equity, hedge funds, etc.) A major tax increase targeting stocks could precipitate a municipal financial crisis in my view.

      Liquidity in the capital markets dries up. Liquidity measures how quickly a security can be bought or sold, at a price close to the last transaction. Since the Great Recession, liquidity in the stock and bond markets has been reduced as the Dodd-Frank Act raised capital requirements for banks and broker/dealers, thus reducing their incentive to hold securities on their balance sheets and "make markets." Liquidity is influenced by investor psychology and market structure. Add an anxious investor class to a broker/dealer network not willing to assume much risk and you get a market panic like the fourth quarter of 2018. Stock prices dropped 20%, the market for junk bonds and initial public offerings virtually shut down and credit spreads on investment grade debt widened significantly. Anxious investors can spark increased price volatility which can cause more panic and more volatility. The fourth quarter market debacle was not an isolated event. It was a warning shot!

      Inflation creeps up, surprising everyone including the Fed. One key reason for the remarkable longevity of the current economic and market cycle is that the U.S. economy never got overheated, forcing the Fed to tighten monetary policy aggressively. Whenever our economy got up a full head of steam, something came along to slow it down and tame inflationary pressures. Most recently it was the weakness in the Chinese and European economies, with a little help from the Fed. Still, through it all, the labor market remained strong and wage inflation continued to trend higher. Now, it's practically conventional wisdom that inflation is dead and the Fed is finished with its tightening cycle. What a surprise to the markets if this wasn't true. With the last year of his first term fast approaching, President Trump has every incentive to stimulate the economy. Is a surprising burst of inflation around the corner? I am anxious to find out. Any unexpected uptick in inflation could lead to a liquidity driven panic in the bond market ... which would eventually impact the stock market ... and then the economy.

      Good grief! Where's my Xanax?