Weekend Reading #31 — Three Body Capital

This is the thirty-first weekly edition of our newsletter, Weekend Reading, sent out on Saturday 24th August 2019. To receive a copy each week directly into your inbox, sign up here.

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Stairway to haven.

Amidst all the noise around “Trade Wars” and a slowdown in global growth, it is no wonder that most industrial metals like Copper and Steel have been performing poorly this year.

HRC steel contracts are -36% from last year’s high, while Copper has been roughly flat the entire year, most notably -13% from the highs of April as hopes for a quick return to the great liquidity fuelled party were disappointed.

Yet there was one big exception to the metals selloff: nickel.

While almost every other industrial metal was sinking under macro uncertainty, nickel has gone on a massive rally, more than +50% this year.

A quick look through the news feed on Bloomberg and Google gives a whole host of possible explanations. Indonesia supposedly (according to a rumour from so and so) bringing forward its raw nickel ore export ban from 2020, tightening up the market. Or maybe the Philippines doing the same. Or perhaps an unknown source of demand growth for batteries (and electric cars). Or other supply concerns around the world.

The problem with these explanations is that there were no reported significant incremental disruptions in supply, and that restrictions on exports of nickel from Indonesia and the Philippines were already well-known. The market may not be completely efficient, but neither does it take more than a year to assimilate that news. A 50% move in 3 months for a globally traded commodity is too big a move to be caused by a tip off.

Moreover, we know from macro data that industrial production is far from stellar, suggesting demand isn’t really bubbling over for nickel, so barring a really severe shortage of supply such a price move was extremely peculiar – especially the timing of the big move, where the price action of nickel for the first half of the year was broadly similar to copper (think “industrial metals”) the decoupling happened in June.

Consider the correlations over the past 2 years (green = nickel, yellow = copper). Largely tight, as one would expect, until June.

This suggests that something strange happened in June to nickel but not copper, and it wasn’t an improvement in global macro conditions across all industrial metals.

A trip to the far left field.

It’s a great asset in any profession is to be a generalist. Seeing the big picture allows us to put together combinations of events and narratives that aren’t always completely obvious in the near term.

Given how we are big fans of fiction, we’re going to put together our theory – a very far left field one, nonetheless backed by data – of what is really happening with nickel. The key ingredients are a sprinkle of history, a dash of imagination and a dollop of big picture perspective.

What changed in June?

What made this June different from every other June in the past 30 years?

Hong Kong, and the extradition bill that has caused so much anguish in one of the most critical financial centres in the world.

This is important, not only because of the Chinese angle which we’ve previously discussed, but also the fact that the dislocation impacts one of the world’s major financial hubs – alongside Tokyo, London and New York, effectively threatening the underpinnings of its viability and existence as a financial centre. Everything from the territory’s Basic Law to the integrity of the HKD/USD peg is starting to be questioned.

As far as the timeline is concerned, things in Hong Kong properly started getting serious in June, with first the law students staging a silent protest (6th June), followed by the first major protest in the streets on the 9th of June, commonly used as the reference point for the start of major public protest (making this weekend the 12th week of major protests). Perhaps more than an unfortunate coincidence with that particular month of June, also in China, 30 years ago.

Now there’s no question about how much Hongkongers love gold as a store of value. As it is with many established financial centres, gold (rather than bitcoin for millenials) is the first port of call in a risk-off scenario. The abundance of outlets belonging to Chow Tai Fook, Luk Fook and other jewellers in Hong Kong, and that market’s ability to move the gold price, is rivalled perhaps only by the Indian domestic jewellery market.

So it’s no surprise that in June, the gold price started to tick up as unrest started to brew:

But it didn’t move alone: the gold line is the price of, well, gold; and the green line should look familiar by now: the price of nickel.

Of course, one does not think of nickel as the greatest store of value. This humble metal, used in the production of ferronickel, stainless steel and more recently rechargeable batteries, particularly for electric cars, is the shiny embodiment of the idea that not all that glitters is gold.

But with this as the possible context behind the nickel move – a risk-off market reaction, we need to take a trip down memory lane, back to 2012. Because to a trader on the mainland, the potential fallout from Hong Kong going south could lead to a similar outcome as what happened in 2012.

What happened in 2012?

2012 marked the year that President Xi Jinping took over the reins of government in China, following which he proceeded to undertake a comprehensive anti-corruption campaign, taking down such illustrious figures as Zhou Yongkang and Bo Xilai, whose political fortunes were toppled overnight and stuffed into the shredder.

As a result of the campaign, the corporate and personal fortunes of many businessmen, politically connected individuals and companies were in upheaval. Fortunes were made and lost, and all efforts were made to try and get whatever wealth had been accumulated till then out of the country – with much more haste than under-the-radar transfers for expensive overseas children’s education could facilitate.

Taking money offshore has always been (and probably always will be) a permanent feature at the top of a Chinese High Net Worth Individual’s to-do list.

That period coincided with what seemed to the world to be a massive “overinvestment” frenzy in industrial metals (sound familiar?), particularly copper and aluminium. Although the impact on the global copper and aluminium prices was less remarkable, the hoarding of inventory managed to draw the attention of analysts and journalists all around the world, inspiring titles such as FT Alphaville’s article on China’s “literally ground-breaking” copper inventories, featuring pictures of the ground at warehouses literally breaking under the weight of copper stockpiles:

While analysts ridiculed the excessive purchases as a “copper fetish” and “compulsive hoarding” leading to China being “buried alive” in copper at the time, everyone missed the nifty tricks that were being played behind the scenes.

It wasn’t until 2-3 years later as copper and aluminium flooded the market that the entire copper financing bonanza, laid out in this convenient anthology by the FT, unravelled and the ingenuity of Chinese traders was revealed.

What was the trick? The short (highly simplified) story was that copper was being bought with domestic currency, imported into China, deposited as collateral in the Shanghai Futures Exchange (SHFE), and the receipts from the deposits were used to back financing in foreign currencies, most notably the US Dollar.

Now that’s a brilliant way of getting cash out of the country, circumventing currency restrictions in the ultimate risk-off trade – going offshore.

A stairway to (safe) haven?

We can’t say for sure that this is what’s happening now, but we can make educated guesses, primarily by comparing the inventories of LME Nickel Warehouses in Asia vs the deliverable/on-warrant inventories in Shanghai:

The white line shows LME nickel inventories in Asia steadily being drawn down, while the green (total on-warrant inventory) and yellow (total deliverable stock) lines reflect inventory in Shanghai.

The first observation is that while stocks in LME warehouses have been depleting gradually as nickel works off a 10 year surplus, in June – what a coincidence – the inventories of nickel in the SHFE started to climb fast, coinciding with none other than the nickel price itself. Cause or effect? We think inventory stocking was the cause, and the price move the impact.

Here’s the same chart, with the LME inventory line removed, and the spot nickel price added in purple:

Too much of a coincidence of location and timing to ignore.

What happens if we're right?

Of course, we could be wrong and be assembling disparate pieces of information to form a narrative suitable for a headline-grabbing article to gain page views. Or we could be half right, and be in the running for a Pulitzer Prizefor explanatory journalism!

If we are right that the swelling demand in nickel is a repeat (same trick, different metal) of the financing schemes put together in China back in 2012, then the elevated prices in place now are bad news for the future of the metal, as higher prices draw in accelerated production, potentially undoing all of the hard work the industry has put in to shed the surplus inventories of the prior 10 years.

The unwinding of the financing trade brought a 58% fall in the copper price from its peak in 2011 (when there was, indeed, a case to be made for real demand for copper in China) to its lows in 2016. Perhaps the coincidence with the end of the “commodity supercycle” exacerbated the price moves, alongside the clearing out of the aforementioned “groundbreaking” copper inventories.

The good news is that off a lower spike this time than what copper had in 2010-12, nickel has perhaps a little less downside than 58%.

Either we’re wrong, or many speculators may soon find their nickel holdings floating like a lead Zeppelin, rather than the stairway to a safe haven they’d imagined.

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What we're doing.

The response to our blog post on "How hedge funds lost their cool" was massive.

In recent days we've been following up on calls and emails from friends who have piled in with their thoughts on the subject. We've clearly hit a nerve (in a good way) and it's got us thinking about our positioning as a business and how we relate to the wider investment management industry. This, in turn, has encouraged us to reach out for input from other managers and thought leaders in the industry.

Asking others for help (and going one step further by actually taking their feedback on board) is always humbling – it can be uplifting too. We're sincerely grateful to everyone who has fed into our thought process this week and we’re looking forward to continuing our discussions.

What we're reading.

This week we've been reading a classic of marketing literature, the somewhat awkwardly titled “22 Immutable Laws Of Marketing”.

Al Ries and Jack Trout, two of the world's most successful marketing strategists, wrote this in the mid 90s and it's stood the test of time. The book is a highly practical guide to brand building and marketing, concerned mainly with hacking consumer psychology in order to break through the noise, find new customers and grow your business.

“The most powerful concept in marketing is owning a word in the prospect's mind."

This really got us thinking about how to sum up our business at Three Body Capital. For us, that word is alignment. Everything we do stems from this concept – we believe that eliminating the pervasive asymmetry between fund managers and investors is a HUGE opportunity and a chance for us to set ourselves apart from 99.9% of other hedge funds and deal platforms. So that's exactly what we're doing.

This week we’ve also been thinking about stakeholders. For the past two decades, the official stance of America’s top executives has been that the interests of shareholders come before those of all others – including workers, consumers and the environment in which companies operate. That all changed this week. At least, superficially.

A lobbying group composed of the nation’s leading CEOs (including JP Morgan bossman Jamie Dimon) announced that its members “share a fundamental commitment to all of our stakeholders” while pledging “to deliver value to all of them, for the future success of our companies, our communities, and our country.”

For fans of crypto, this is old hat. Tokenomics has always prioritised stakeholders over shareholders, and Binance in particular has a vision of a world where token value supersedes equity value. That’s why it’s ruthlessly optimising for the value of BNB rather than equity holders. The decentralised era is making it easier for companies to be run by and for stakeholders rather than shareholders, and investors need to be aware of the risks and opportunities this movement presents.

Andreessen Horowitz recently wrote about this in a blog post entitled “Shareholders vs. Stakeholders? No: Customers”. The conclusion, as always, is more complicated than a simple yes/no. They argue that well-managed corporations have always recognised that it's possible to maximise long-term shareholder value and respect people both within and beyond the organisation.

No wonder then, that a16z is investing so heavily in crypto.

What we're listening to.

You probably haven't come across the name Nir Eyal. But he's had a big influence on your life. In fact, he's a big influence on all of our lives.

That's because Nir Eyal has spent his career perfecting the science of motivating and manipulating technology users. Many of the apps and products we use every day have his fingerprints on them.

Nir’s interview with the legendary Cal Fussman is a great insight into the power of behavioural design and one man’s incredible professional journey. What's fascinating is that the poacher has now turned gamekeeper with a book entitled "Indistractable", intended to help people control their attention and lead a more focused life.

Listening to this might just change the way you think about technology.