May investment letter from Northwest Passage Capital Advisors

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“Et Tu, Draghi” May 2015
Human beings, by their nature dislike change. There is an underlying assumption of
risk in uncertainty. As a result, established trends instill a high degree of comfort in
people and an increasing level of confidence; perhaps falsely. Trend reversals, on
the other hand, create fear and anxiety when in fact they are natural and inevitable.
The key to managing cycles is a knowledge and experience.
Weather, for instance, is constantly changing. The key to understanding change is
to determine the dominant trend, versus what is of a temporary or transitory. For
instance, six days of rain in a desert is unlikely to signal the birth of an oasis. Short
term volatility distorts one’s ability to recognize a dominant trend.
Dominant trends, rather than then short term noise, are more discernible in the
study of longer term change. The Earth undergoes a geomagnetic reversal on
average every 450,000 years with a range of 100,000 years to 1,000,000 years. The
magnetic fields of a planet are created from electric currents generated from the
convection of molten iron within its core. Periodically, in a random and
unpredictable fashion, these polarities change. There is no determining what is
“normal”. Normal is simply believed to be the condition that exists in the present.
Financial markets can behave in similar fashion. The long term path of U.S. interest
rates has been lower, while the path of U.S. equity markets has been higher.
Returns over 30 years have been similar. Is this normal? Is the correlation between
debt and equity market returns merely a reflection of the discounting mechanism?
Or, do risk assets indicate increased potential for prosperity? Are lower interest
rates a reflection of fear?

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We have come to understand human progress as normal and evolutionary. We
have had increasing productivity, innovation, growth and resulting higher
standards of living since the beginning of time. To some extent financial market
returns are a direct reflection of that progress. However, from time to time and for
no apparent reason this progress stalls. To mitigate the damage, we intervene by
introducing incentives to protect our gains and to promote the interests of those
who have attained those gains.
Mr. Draghi was recently quoted,
“In particular, there have been concerns that very low rates for a prolonged period
might penalise savers to the benefit of debtors; or that rising asset prices as a
consequence of our purchases might benefit the wealthy disproportionately and
thereby increase inequality… In the case of an unexpected undershooting of
inflation, data for the euro area suggest that younger households (from 16 to 44
years old) would be most affected. They tend to be net debtors… In contrast, older
households tend to have positive net wealth, some of it held in nominal assets.
Inflation undershooting therefore results in redistribution from younger to older
households… That being said, we have to be mindful that too prolonged a period of
very low real rates can have undesirable consequences in the context of ageing
societies… For pensioners, and for those saving ahead of retirement, low interest
rates may not be an inducement to bring consumption forward. They may on the
contrary become an inducement to save more, to compensate for a slower rate of
accumulation of pension assets. However, I would submit that it would not be in the
genuine interest of those savers if the central bank gave up on its mandate. On the
contrary, the interest of long-term savers is that output be raised to potential
without undue delay. This is because their financial assets are always, in the final
analysis, a claim on the wealth generated by the productive part of the economy.
So it is in their interest that output growth remains on a robust path as this
maximises the likelihood that their claims are honoured in full. At the same time,
the more monetary policy is able to encourage investment, the faster interest rates
will return into more normal territory…”
Throughout history these interventions have failed. The heavy debt burden of the
developed world, when combined with a deteriorating demographics have

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temporarily stalled progress. Technology, which has the potential to restore the
positive trend of human progress over time, can be disruptive in the short run.
Capital and labor markets must undergo transition and adjust. This can be painful
and costly. Creative destruction adds to the deflationary tendencies.
The price mechanism of capitalism, if left alone, is the most efficient and fairest
manner in which to adjust to change. Yet, political considerations require that
policymakers intervene. At best these policies can postpone the adjustment and
smooth the transition. With the world pointed in the direction of slower growth,
less inflation and increased indebtedness, they have their work cut out for them.
Central Bank actions which were arguably necessary during the financial crisis may
no longer be appropriate. Their exit plans may prove to be ill timed.
Monetary policy is at an extreme and will be less effective in smoothing future
economic cycles. While the economic impacts have been muted, financial
conditions have improved dramatically. The resulting market response must be
validated by real economic growth at some point.
Financial markets have recently experienced highly correlated trend reversals.
Perhaps, the change in polarity is related to the relative disappointment of U.S.
economic growth and encouraging signs from Europe. The convergence should
come as no surprise given the sizable adjustment to the European currency,
interest rate differentials and declining oil prices. The European economies have
much greater sensitivity to these shifts in macro trends. Further, hopeful signs of
more accommodative polices in China hold the promise of improved trade for
Europe.
Deflation has been averted for the time being and employment, housing and auto
demand have shown relative strength. We have no doubt that the underlying shift
in trend that occurred during the financial crisis will be long lasting. We do doubt
that the recent reversals will be sustained for more than several months. Rates can
certainly rise over the next year, oil prices can trend higher and even the Euro can
retrace some of its decline. In fact, we believe they will. The problem remains that
higher rates, energy prices and a stronger dollar will serve to cap economic
progress. As a result, we expect these reversals to revert to the dominant trend.
Counter trend rallies can be useful in helping to positon portfolios. We intend to
use the opportunity.

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Geomagnetic and financial reversals share many things in common. They are
unpredictable and random. However, once they occur they tend to persist for a
long while.
Jefferson V. DeAngelis
Chief Investment Officer
172 North Broadway, Suite 300
Milwaukee, WI 53202
414.755.0461
jvd@nwpcapital.com
© Northwest Passage Capital Advisors LLC 2015 – All Rights Reserved. This report is provided for
information purposes only and is not a solicitation or offer to either buy or sell any securities or
investments, or to provide investment advisory services, or to engage in any other transaction. While the
information in this report is based on sources and data Northwest Passage believes to be reliable,
Northwest Passage does not assume any liability or guarantee for the timeliness, accuracy, and
completeness of the information provided. The information in this report is provide “as is,” and
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expressly or impliedly, for any particular purpose, and expressly disclaims any warranties of
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