Weekend Reading #29

This is the twenty-eighty weekly edition of our newsletter, Weekend Reading, sent out on Saturday 10th August 2019.

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This is not a trade war.

Protect the integrity of The Realm.

It's a notion made popular in contemporary culture by one Lord Varys of Game of Thrones fame, in his conversation with Ned Stark:

“Tell me something, Varys. Who do you truly serve?”
“The Realm, My Lord. Someone must.”

But more than a century before George R. R. Martin created Varys, in a speech to the House of Commons on the 1st of March 1848, the British Foreign Secretary (and later twice Prime Minister) Lord Palmerston remarked:

“We have no eternal allies, and we have no perpetual enemies. Our interests are eternal and perpetual, and those interests it is our duty to follow.”

This remark was made in the context of Britain’s profound fear, at the time, of both France and Russia, and the revolutionary fervour spreading through the continent, largely at odds with the Victorian conservatism of the time. While the status quo would hardly be analogous to Britain’s artful and subtle statecraft of the time, the complexity of the situation that Lords Palmerston and Varys faced does find its match.

As we look upon the ongoing skirmish between Trump and China, the common narrative is that this is all about trade and winning elections. “Trump” of course could be any other name – the conundrum would have been faced by any other president in office, although the approach may not have been as confrontational.

But this is not a trade war. Neither is it a containment exercise. Those are two important battles, at least from the US side, but the underlying war is more defensive. Just like Lord Palmerston and Lord Varys, the aim is to protect the realm.

No, this is a clash of civilisations, ideologies and belief systems, happening in a world where the big picture narrative of US hegemony over all things geopolitical and economic is increasingly being challenged.

Welcome to #TheGreatGame.

Re-enter The Eagle and The Dragon.

We’ve always been fans of the notion that the story constructed around the facts is almost as important as the facts themselves. We see recent happenings (of which the escalating trade conflict is the most visible but not, in our view, the most critical), falling into a much bigger conflict, with much larger consequences. 

We previously wrote about "The Eagle and The Dragon", with the conclusion being that the real losers from this conflict will not be the US, or China, but everyone else caught in between. And indeed that has been the case. While the rest of the world looks for weakness as a trigger for a rate cut cycle so that they, too, may enact monetary easing without currency depreciation risks, economic growth in the US and China for now remains relatively robust, although signs of weakness are rapidly starting to show.

This time, we thought it would be helpful to try and look beneath the surface of what is being said and done on both sides, taking into consideration as many pieces of publicly available information and statements as possible.

The American view.

On the surface, the entire episode has been a question of “fairness” and “making things right/great again”, with the bulk of the blame placed squarely on China as having taken advantage of the global geopolitical security provided by US hegemony, thanks to its institutions, both civilian and military. The narrative circulating in the mass media is that China is neither behaving itself nor playing fair, from intellectual property protection to trade to human rights. 

As a result, China has gained an unfair advantage over the rest of the world, explaining its phenomenal growth over the past decades, and must now be punished for flouting the rules of global engagement and be made to pay reparations, most surely to the US, the global hegemon under whose umbrella of safety and security it has been able to prosper. Or so the narrative goes.

Observers of history look optimistically to how the US treated Japan in the 1980s as an indicator of how this may all pan out. As Japan was rising as an industrial power, the US started to take steps to contain Japan’s growth through trade policies and threats of retaliation. Most of the friction at the time stemmed from US industries seeking protection from Japanese imports, including textiles, steel, televisions and automobiles. 

The key difference was that the Japanese bent the knee. In almost all cases, disputes were settled when Japan voluntarily restrained exports of the disputed items, firstly to the US, and ultimately to other major trading blocs like the EU.

Yet despite the US continuing to extract growing trade concessions, Japan rarely lodged official complaints against these measures. It wasn’t in a position to push back (mainly because the US military presence was protecting their realm), and that suited US politicians well too, whether or not it was reflective of the true economic reality.

This time, however, things are different. It is once again a struggle for the #1 position globally, with the Americans looking to their old playbook to contain the rising challenger to their position, only this time the challenger is in a much stronger position, seemingly built up by stealth while the US wasn’t paying attention, in the aftermath of the 2008 financial crisis.

Unlike Japan, China is strategically important both as an importer and exporter to large swathes of the world, thanks to Globalisation. It is a critical supplier into the US supply chain, especially in tech – now the crown jewel of American corporate culture. And where the US has been financing the security and stability of the entire world, China has been building out its influence in the vacuum that the US and the former colonial powers have left behind – places like Africa, Indochina, Central Asia and Latin America. Moreover, it has done so under a system of values, ideology and governance that is diametrically opposed to almost everything that America stands for – democracy, liberty and US hegemony.

Therein lies the sting that cannot be tolerated. China is not only threatening the US as the #1 economy in the world, it is threatening the very existence and integrity of the US hegemony, offering an alternative to the status quo that actually works. 

The threats are real. China and Bitcoin. Yes, that’s not a typo! When members of the House of Representatives start calling for a crypto ban because “it is the announced purpose of the supporters of cryptocurrencies to take that [awful lot of international] power away from us”, it’s clear what the bigger picture in their minds is.

The realm must be protected.

And what might the Chinese view sound like?

Critics of China look to its recent communist history and reignite the fears of “Yellow terror” perpetuated in the Domino Theory held by the US administration in the post World War 2 era. They think that China’s aim is to colonise the world by stealth, eventually establishing a global communist bloc administered from Beijing, putting an end to human rights and all that is good and beautiful.

As put by US President Dwight D. Eisenhower in articulating the risk of Vietnam falling to Communism in Indochina on the 7th of April 1954:

“Finally, you have broader considerations that might follow what you would call the "falling domino" principle. You have a row of dominoes set up, you knock over the first one, and what will happen to the last one is the certainty that it will go over very quickly. So you could have a beginning of a disintegration that would have the most profound influences.”

We find opinions and extrapolations from the past like this extremely dangerous for multiple reasons, not least because they attempt to superimpose the modus operandi of western colonialism on a persona of China that has also been developed from a western perspective.

In contrast, we believe the Chinese view to be much more insular than popularly imagined. Speak with anyone who has spent time in China and they will have stories of being told about China’s 5000 years of history, punctuated by dynasties, warring states, factions, feudal lords, opium wars, a communist revolution and more recently a re-integration into the global economy.

As far as this history has gone, the past 100 years (well actually it’s a bit longer than that) have been a century of humiliation. For China, the next 100 years are about re-establishing the realm and protecting its integrity, particularly territories in Xinjiang, Tibet, Hong Kong/Macau and, ultimately, Taiwan. The good of the realm justifies all manner of sins.

That’s it. No dreams of global conquest or ideological propagation, and most certainly not of the Marxist/Leninist stripe. Of course there is the odd nudge and handshake here and there, but nowhere near the active intervention and cultural assimilation practiced by imperial colonialists. It’s good to be rich and developed, certainly not poor and communist, and the only ask is it’s done the Chinese way.

In our view, China is purely concerned with the integrity of the Greater Chinese realm. While territories that it considers its own need to be reclaimed, it’s amicably transactional with the rest of the world – as were the great Chinese dynasties of centuries past. Governing from a distance, if it would ever come to that, would be a (less preferred) means to an end of security, rather than an end in itself.

These dynasties adopted what Western historians subsequently termed a “tributary” system, not so much in the sense of a coercive hierarchy (as one would imagine), but rather a form of “symbolic obeisance”, with one member acknowledging the superior position of another, securing opportunities for peace, investiture and trade, with all members remaining largely autonomous despite paying tribute. This is in contrast to the imagery of top-down sinocentricity conjured up by contemporary narratives.

Pay to play, that’s business as usual. Which is why the Belt and Road initiative, often seen as a new form of “economic colonialism” is something frequently misunderstood. Unlike classic imperial colonialism where a colonial power arrives, subjugates the native population and extracts resources without compensation, the Chinese actually pay up for everything that they buy in a throwback to the imperial days of the Silk Road. And most importantly it opens the inbound taps for a gargantuan population that is severely unfavoured by mother nature in terms of its own natural resources.

From the Chinese standpoint, therefore, their dealings in the global sphere are fair game and perfectly reasonable. So why are they being greeted by so much grief when everything has been working so well for so long?

Securing their national interest is China’s top priority, whatever it takes - and we think they mean it quite literally. By that logic, just as Russia found it completely sensible to march their army into Crimea and Eastern Ukraine to protect its own realm in 2014, we wouldn’t find it surprising at all should the PLA enter Hong Kong to “control” the current situation. 

Where does the story lead?

Everyone believes they are acting with the unquestionable loyalty to the realm. But to which realm?

It’s all a function of which perspective we take. We’ve written extensively about how narratives matter, and also about how storytelling enables us to disengage the ego and examine situations through the eyes of others.

What we’ve attempted to do is put ourselves in the shoes of each party in this great game that is being drummed up. Because even though we call it #TheGreatGame, its consequences are real. The stories that each side tells itself perpetuate a resulting set of actions that have ramifications all around the world, most visibly in markets.

Our answer to the question is that we honestly don’t know. But as we like to say, there are always multiple paths that a story can take from any given point, and our job is to work out as many of those paths as possible and have a plan for them, using the clues provided to action that plan into place as the story unfolds.

As with everything, there’s the big play, and there’s the small play. Figuring out the right play? That’s something that will need more than one perspective to work out. But hopefully we’ve given you a new perspective to consider.

n.b. Please note that none of our musings above are intended to talk about current economic trends, including the highly topical debate about China’s current economic situation, the leverage in the banking system, the renminbi etc. Of course this is all critical in the above mix but we save that for another time!

What we're doing.

This week we’ve spent lots of time thinking and talking about deal-making.

We didn’t launch Three Body Capital to be like other investment managers and deal platforms. We did it because we think there is a fundamental mis-alignment of interests in our industry, one that presents big opportunities for those brave enough to try something different.

Most brokers of private deals get paid a fixed fee by either the seller or the buyer (typically a percentage of the deal size) which can result in perverse incentives, as the intermediary is incentivised to do a deal regardless of the long term consequences for their clients. We want to be aligned with both the seller and the buyer and we want to have skin in the game. This is critical if we are to succeed in our mission to offer something different and avoid becoming another me-too fintech business that peddles disruption but ultimately clings to convention. Our global network of professional investors needs to know we’re aligned – that we’re not just pushing deals so we can earn fees, regardless of the outcome for them.

But how to square the circle and align the interests of buyers, sellers and intermediaries? Having thought long and hard about this, our preferred option is to take a success fee paid in equity (or whichever instrument is being sold) instead of cash, along with a small base fee paid in cash to cover the cost of getting investor marketing materials to the point where it meets the standards of our platform, which often involves travelling to local markets to perform our own due diligence and get to grips with company fundamentals as if we were investing ourselves.  This aligns us with long term outcomes for BOTH the buyer and the seller, as both will hold this instrument going forward in the vast majority of the cases.

Our thinking is still evolving on this topic, but we wanted to share our thought process with you. We understand that this model is not perfect, but there rarely is a perfect solution! Please get in touch if you feel strongly about this. We’re keen to hear a range of perspectives as we drive towards the official launch of our online deal platform in the autumn.

What we're watching.

This week we watched a documentary about something very strange – and very interesting. HyperNormalisation is a 2016 BBC documentary by British filmmaker Adam Curtis. It argues that governments, financiers, and technologists have rejected the complex “real world” and built a simpler “fake world”, run by corporations and stabilised by politicians who are complicit in the conspiracy.

If you think this sounds fantastical and absurd, so do we. But the wackiest ideas sometimes contain valuable nuggets of truth. And this is certainly an interesting theory, one that can help us to interpret events unfolding on a macro level in a new light. The accommodative behaviour of central banks since the mother of all financial crises is a case in point. 

For those who wish to dig deeper into this topic, the word "hypernormalisation" was coined by a fellow called Alexei Yurchak, a Russian professor of anthropology who studied life in the Soviet Union during the 1970s and 80s. He argues that although everyone knew the system was failing and society was falling apart, few people could visualise an alternative to the status quo. So people were resigned to maintaining the charade of a fully functioning society. Over time, this delusion became a self-fulfilling prophecy. Artificiality was accepted by everyone as real. The parallels to the current state of the financial services industry – which is inefficient, regressive and dangerously fragile – are stark.

As fund managers we must NEVER accept the status quo. In order to deliver absolute returns, we must be absolutely committed to thinking differently and stepping outside the Matrix. We must reject the blue pill for the red.

What we're reading.

Magazines are falling out of fashion. Not here. This week we picked up our copy of Wired (we are subscribers), full of excitement over the cover story on DeepMind, the Alphabet-owned artificial intelligence business headquartered in London’s Kings Cross (a superhuman cricket ball throw from our offices in Camden).

The company set out with a hugely ambitious aim – to "solve intelligence" i.e. develop Artificial General Intelligence that can be applied in multiple domains. What’s interesting is that it’s chosen to tackle this by playing games, specifically Breakout, chess and Go. The next step in the company’s journey will take it out of its comfort zone as it seeks to crack problems in chemistry, physics and biology.

But the coolest thing about this article is its profile of DeepMind's co-founder and CEO, Demis Hassabis. As well as being CEO, he is also a researcher, which means he has to be highly structured with his time in order to balance business with pleasure (in this case, academic research). During the working day, Hassabis wears his CEO hat. Then he returns home for dinner with his family before embarking on his “second day” after 10pm, during which he conducts his research. 

“I love that time,” he says. “I’ve always been a nocturnal person, since I was a kid. Everything is quiet in the city and the house and I find it very conducive to thinking, reading, writing."

The questions is, when does this incredible dude sleep?!

We also spotted this article on Silicon Valley’s latest unicorn, Scale AI. The company has built software that takes a first pass at marking up pictures before handing them off to a network of over 30,000 contract workers, who perform the finishing touches. In other words, Scale AI teaches machines to see. Results are fed back into AI that learns how to do the same thing over time.

It’s a great example of the ecosystem that’s springing up around hardcore “Real AI” companies, a topic we shall be visiting in more depth soon, via this newsletter. So don’t you dare unsubscribe!