>“You cannot spend your way out of recession or borrow your way out of debt.”

The “Good” News?
The “good” news is the recession is officially over. Real GDP dropped only 4% peak‐to‐trough, S&P 500 revenues dropped only 18%, and home prices dropped only 31.3% nationwide. Broad‐based unemployment (including the underemployed) reached 17.0%, which translates into 17.4 million Americans out of work and another 9.2 million working part‐time jobs that are insufficient to pay their bills.1 After losing an average of 578,346 jobs every week since October 2008,2 the headline unemployment figure improved in July from 9.5% to 9.4%. Never mind that in August the Bureau of Labor Statistics (”BLS”) revised their prior estimates, and a portion of the “improvement” in July was achieved by adjusting the total size of the labor force (think increasing the denominator to reduce the percentage) and unemployment continued its upward trajectory to 9.7% in August and 9.8% in September. We are left wondering how broad based unemployment went from its most recent trough of 7.9% in December 2006 to 17.0% currently, while total retail sales declined only 3.6% over the same time period.

Bernanke and crew have done a masterful job of pulling out all of the stops (and then some) to save the US and world banking system from collapse. Having gone from potential collapse to valuations well above the 10‐year averages, the S&P 500 now trades at 2x book value and 20x EPS and credit spreads relative to Treasuries are back to pre‐Lehman levels.

Where We are Bullish
There are great businesses which have too much leverage, which are being or will be recapitalized through consensual restructurings or Chapter 11 bankruptcies. These “capital transformation investments” usually involve buying senior debt and working with the company’s stakeholders and management to craft a plausible capital structure to return the entity to health and growth. As the capital markets have recovered, money is flowing and many private equity players are prepared to invest in their existing portfolio companies after or in conjunction with a debt restructuring. It is in these types of situations that we see great opportunity. Our investments are focused on asset‐heavy businesses where we can buy into the right portion of the capital structure in advance of the restructuring. On the back end, we will likely end up owning some amount of senior debt with attractive current pay characteristics and in certain circumstances end up holding equity in the company for little, if any, real cost. This is one area where we are acutely focused and we believe presents the most asymmetric returns for being invested on the long side.

If the story could just finish here with such a happy ending – unfortunately, here is where the really bad news begins.

Never Before and Hopefully Never Again
Western democracies, communistic capitalists, and Japanese deflationists are concurrently engaging in what may be the largest, global financial experiment in history. Everywhere you turn, governments are running enormous fiscal deficits financed by printing money. The greatest risk of these policies is that the quantitative easing will persist until the value of the currency equals the actual cost of printing the currency (which is just slightly above zero).

There have been 28 episodes of hyperinflation of national economies in the 20th century, with 20 occurring after 1980. Peter Bernholz (Professor Emeritus of Economics in the Center for Economics and Business (WWZ) at the University of Basel, Switzerland) has spent his career examining the intertwined worlds of politics and economics with special attention given to money. In his most recent book, Monetary Regimes and Inflation: History, Economic and Political Relationships, Bernholz analyzes the 12 largest episodes of hyperinflations – all of which were caused by financing huge public budget deficits through money creation. His conclusion: the tipping point for hyperinflation occurs when the government’s deficit exceed 40% of its expenditures.

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