“[The] virus is like a huge sink hole in global economy. No one (not even anyone on this chat!) knows how big/deep it is. And every day world in lockdown it gets bigger and deeper. Policy makers also have no clue, but they have to do something, so they have started shoveling fiscal and monetary ‘dirt’ into hole. If hole bigger than dirt, we get deflation and you do the obvious. If dirt bigger than hole, you get . . . inflation. And if by complete dumb luck, dirt=hole, back to Goldilocks.”
All models are abstractions and by extension all models are thus untrue. But, models can be useful in understanding and visualizing key aspects of reality. The Dirt and the Hole is a good model to use to answer the question, "What the heck is going on with the markets?" There is indeed a huge Hole in the economy caused by the lockdowns. There is also a whole lotta Dirt. So far governments and central banks have shoveled about $20T of monetary and fiscal Dirt into the Hole. This sum includes roughly $10T in the United States alone.
The main initial goal of central banks and governments is to keep asset prices up so that the Hole doesn't grow explosively larger by bankruptcies and forced deleveraging. Explosive Hole growth is what we were seeing in mid-March when the stock indexes were bleeding 10% per day on several instances and oil traded at negative 40 dollars per barrel. Governments and central bankers don't have to fill the entire Hole themselves when it comes to keeping asset prices inflated. It is enough to convince the market that they will if needed. When that happens, borrowing, leverage, and speculation take care of the rest. Investors and speculators will rush to front-run government and central bank buying. This is what we've seen since mid-March and our portfolios continued to benefit during May.
Where the model breaks down is in that final sentence referring to dirt=hole resulting in Goldilocks. The issue is that while the Hole is real, the Dirt is not. Economic activity involving the production of goods and the provision of services really face-planted. Planes stopped flying, cars and trucks stopped driving, factories shut down, and restaurants, bars, sporting events, and travel industries were decimated. On the other hand, the fiscal and monetary Dirt appeared out of thin air and doesn't represent real replacement of goods, services, and lost jobs. So the Dirt went into the Hole. The result was asset price levitation, or even increases in some cases. The future cost will be collected from all of us in some combination combination of taxes, inflation, and slower economic growth.
In an interventionist world as we have today, the value accrues to the holders of assets...the more leveraged, the more accrual of value. Meanwhile, everyone else in the economy pays. But they pay in the future and the link to the payment is obscured and widely misunderstood. If this sounds unfair to you, it is! This is why government and central bank manipulation is so corrosive for societies and economies. It is the opposite of capitalism and in fact slowly destroys capitalism and its benefits. Expect to see more social unrest, declining economic mobility, and increased wealth disparity as long as these policies continue. And continue they will, since these interventions have been applied so many times (think the Dotcom Bust of 2000, or the Great Financial Crisis of 2008-2009) and for so long that markets have come to expect them and policy-makers deem the consequences of not intervening in markets to be too painful to abstain.
But as investors, we have to make decisions based on reality not wishful thinking. It is what it is. We too must expect intervention and its consequences and do our best to align our portfolios with those realities. We know that because of interventions, what happens in the economy doesn't equal what happens in markets. So we continue to hold stocks that trade at reasonable valuations. We protect our portfolios from a bigger Hole with high quality US Treasury Bonds. And we protect them from too much Dirt (and the inevitable consequences of Dirt creation) with monetary metals and natural resource producers.
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