Let me take a step back. Many people think that inflation will follow the massive government stimulus (both fiscal and monetary) that responded to the recession and financial crisis. That's not notable. But hyperinflation is a sort of extreme doomsday scenario. That would mean inflation in the ballpark of 30% per year -- at least. Generally hyperinflation is measured by the month or day, not year, because the numbers are so high.
This section from the letter describes the quantitative basis for the hyperinflation worry:
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.
According to the current Office of Management and Budget ("OMB") projections, US federal expenditures are projected to be $3.653 trillion in FY 2009 and $3.766 trillion in FY 2010 with unified deficits of $1.580 trillion and $1.502 trillion, respectively. These projections imply that the US will run deficits equal to 43.3% and 39.9% of expenditures in 2009 and 2010, respectively. To put it simply, roughly 40% of what our government is spending has to be borrowed. One has to ask whether the US reached the critical tipping point?
This is an interesting point, because it's a hyperinflation argument that doesn't seem wacky -- it's rooted in historical observation. And it also has nothing to do with the massive monetary stimulus by the Federal Reserve, which could cause additional inflationary pressures. So even if you believe that the Fed can control their side of the equation, the government spending might still cause inflation to get out of hand, according to the logic presented above.
I remain skeptical, mostly because the U.S. has a more robust, developed and sophisticated economy than most places where hyperinflation has occurred. I find it very hard to believe that fiscal and monetary policy wouldn't be seriously altered to avoid incredible levels of inflation if the U.S. found itself facing such a predicament. Still, successfully keeping inflation as low as it has been in recent years seems unlikely.
So what's the fund management's strategy? They're investing in mortgages and high-yield debt. That combination accounts for 75% of their portfolio. If inflation increases substantially, then debt will be easier for borrowers to keep up with, making the high yields those types of debt provide safer than they would otherwise be. Rising interest rates, the presumed response to significant inflation, would also make refinancing of this debt less likely. They appear to be a bit bearish on the stock market, but also note that they have positions in precious metals and natural resources -- other good bets if you expect inflation.
They're shifting their investment to this mix immediately, rather than later. Given the magnitude of the stimulus, they think inflation will start soon -- not 18 to 24 months after stimulus, what they say is the traditional amount of time it takes. Due to the state of the economy and the possibility of prolonged low growth, I find it hard to believe that price levels will start increasing immediately, however. If we get bad inflation, I would be quite surprised to see it happen much before 2011.
Whether you buy into the fund's logic or not, its letter is an interesting one. It also provides analysis on China and Japan. If you have some time to kill and interest, you might want to give it a read.
