Financial Times Weekend 22-23Feb2020

22 February/23 February 2020 ★ FT Weekend 11

Opinion

3 A climate transition will not happen by

itself

Achieving zero emissions by 2050 requires

global co-operation, writesMartin Wolf

Top reads at FT.com/opinion

3 Big Tech companies want to act like

governments

They must treat their customers as citizens,

writesMarietje Schaake

standing of financial markets and capi-

tal markets and the hundreds of differ-

ent types of instruments that you do.”

Many people outside finance know

Mr Milken and his family foundation,

founded with his brother, for their good

works.

A prostate cancer survivor, he has

become a campaigner against the dis-

ease. The Milken Educator Awards have

provided cash grants to thousands of US

teachers. There is even a Milken Archive

of Jewish Music.

Probably the most poetic manifesta-

tion of the family’s largesse can be found

in Fort Scott, Kansas, home of the Low-

ell Milken Center for Unsung Heroes,

which introduces children to role mod-

els who “have made a profound and pos-

itive impact on the course of history”.

The dozens of people honoured at the

exhibit do not include any bond traders,

but it is easy to imagine how the Milkens

were attracted to the idea.

[email protected]

ans also play an outsized role on Wall

Street. David Solomon, chief executive

of Goldman Sachs, worked there, as did

the leaders of firms including Apollo,

Moelis and Jefferies.

After leaving prison in 1993, Mr

Milken faced new allegations over com-

pliance with his ban from the securities

industry. In 1998, he paid $47m to settle

allegations that he came too close to his

old trade.

He still plays the role of grandee at the

think-tank he founded, the Milken

Institute, which hosts 200 events every

year. Last April, he singled out Soft-

Bank’s Rajeev Misra for praise, saying:

“There is no one that has the under-

immense — in the 1980s, Drexel regu-

larly accounted for half of junk-bond

issuance. His personal share was enor-

mous — $550m in 1987. And his inten-

sity was legendary. After moving from

New York to Los Angeles in 1978, he

started at 4:30am and worked into the

night at an X-shaped desk.

The problem was that like many pio-

neers, Mr Milken had the opportunity —

and the tendency — to play by his own

rules. He pleaded guilty to six criminal

counts ranging from filing a false regula-

tory report to mail fraud and securities

fraud. In return, prosecutors dropped

92 other counts against him and all

charges against his brother, Lowell, a

lawyer at the Beverly Hills Drexel office.

With Mr Milken gone, Drexel col-

lapsed, and the high-yield bond market

faltered. “Junk bonds lived up to their

name,” Warren Buffett told his share-

holders at the time.

But Mr Milken’s junk revolution con-

tinued without him and the market is

now bigger than in his day. Drexel veter-

M

ichael Milken cried in

court when he pleaded

guilty in 1990 to violating

US security laws. After

his pardon this week by

Donald Trump, Wall Street’s one-time

junk bond king was more measured. He

issued a statement mentioning his wife

of 51 years, thanking the US president

and expressing his commitment to phi-

lanthropy.

If that response seemed rehearsed,

perhaps it was. Now 73, Mr Milken had

spent the better part of his adult life pre-

paring for that day. Since being banned

from the securities industry, paying

$600m to the government and investors

and serving 22 months of a 10-year

prison sentence, he has worked as

relentlessly to burnish his image —

funding cancer research and starting a

think-tank — as he once did to push

high-yield debt securities.

Few people in Wall Street history have

a more complicated legacy. Today’s

world would be unimaginable without

Mr Milken’s contributions — which are

reflected in the size of the junk bond

market and the ubiquity of the lever-

aged buyout. But he was a man who bent

the rules in a “greed is good” era, and

that has tended to overshadow his inno-

vations, leaving him feeling under-ap-

preciated.

“I regret that the American public

didn’t understand,” Mr Milken said

recently when asked about his career.

“Almost every person is high-yield

junk... The American public didn’t

understand that they were talking about

themselves — 60m jobs being created by

non-investment-grade companies in the

latter third of the 20th century.”

Mr Milken found financial enlighten-

ment in an unlikely place — the Univer-

sity of California, Berkeley in the 1960s.

While his contemporaries were fighting

to end the Vietnam war or letting their

freak flag fly, Mr Milken, the son of a

southern California accountant,

became a devotee of W Braddock Hick-

man’s 1958 opusCorporate Bond Quality

and Investor Experience.

After examining all corporate bonds

sold in the US from 1900-43, Hickman

found that investors would have done

better with a portfolio of riskier credits

than supposedly safe ones. As LSD was

to Timothy Leary, Hickman was to Mr

Milken: he set out to turn the world on

to his countercultural discovery.

Setting up shop at Drexel Burnham

Lambert, Mr Milken found a Wall Street

that was far from hip, however.

Although high-yield bonds were numer-

ous in the 1920s and 1930s, the category

in the 1970s consisted of a small number

of “fallen angels” — higher-rated bonds

that had been downgraded.

So Mr Milken created a market of his

own, graduating from the trade in fallen

angels to underwriting junk bonds and

then unleashing the power of high-yield

debt in the service of buyouts and hos-

tile takeovers. A letter from Drexel say-

ing it was “highly confident” of securing

financing for a corporate raider was the

1980s equivalent of a Trump tweet in its

power to scare chief executives.

Mr Milken’s market might was

Person in the news| Michael Milken

Newly pardoned

junk bond king

This week’s action has

been a long time coming

for one of Wall Street’s

most controversial figures,

writesGary Silverman

Like many pioneers Milken

had the opportunity — and

the tendency — to play

by his own rules

T

he UK’s national weather

service, the Met Office, is to

get a £1.2bn computer to

help with its forecasting

activities. That is a lot of sil-

icon. My instinctive response was: when

do we economists get one?

People may grumble about the

weather forecast, but in many places we

take its accuracy for granted. When we

ask our phones about tomorrow’s

weather, we act as though we are gazing

through a window into the future.

Nobody treats the latest forecasts from

the Bank of England or the IMF as a win-

dow into anything.

That is partly because politics gets in

the way. On the issue of Brexit, for

example, extreme forecasts from parti-

sans attracted attention, while inde-

pendent mainstream forecasters have

proved to be pretty much on the money.

Few people stopped to praise the eco-

nomic bean-counters.

Economists might also protest that

nobody asks them to forecast economic

activity tomorrow or even next week;

they are asked to describe the prospects

for the next year or so. True, some alma-

nacs offer long-range weather forecasts

based on methods that are secret,

arcane, or both — but the professionals

regard such attempts as laughable.

Enough excuses; economists deserve

few prizes for prediction. Prakash Loun-

gani of the IMF has conducted several

reviews of mainstream forecasts, find-

ing them dismally likely to miss reces-

sions. Economists are not very good at

seeing into the future — to the extent

that most argue forecasting is simply

none of their business. The weather

forecasters are good, and getting better

all the time. Could we economists do as

well with a couple of billion dollars’

worth of kit, or is something else

lacking?

The question seemed worth exploring

to me, so I picked up Andrew Blum’s

recent book,The Weather Machine, to

understand what meteorologists actu-

ally do and how they do it. I realised

quickly that a weather forecast is inti-

mately connected to a map in a way that

an economic forecast is not.

Without wishing to oversimplify the

remarkable science of meteorology, one

part of the game is straightforward: if it’s

raining to the west of you and the wind is

blowing from the west, you can expect

rain soon. Weather forecasts begin with

weather observations: the more obser-

vations, the better.

In the 1850s, the Smithsonian Institu-

tion in Washington DC used reports

from telegraph operators to patch

together local downpours into a

national weather map. More than a cen-

tury and a half later, economists still

lack high-definition, high-frequency

maps of the economic weather,

although we are starting to see how they

might be possible, tapping into data

from satellites and digital payments.

An example is an attempt — pub-

lished in 2012 — by a large team of econ-

omists to build a simulation of the

Washington DC housing market as a

complex system. It seems a long way

from a full understanding of the econ-

omy, but then the Smithsonian’s paper

map was a long way from a proper

weather forecast, too.

Weather forecasters could argue that

they have a better theory of atmos-

pheric conditions than economists have

of the economy. It was all sketched out

in 1904 by the Norwegian mathemati-

cian Vilhelm Bjerknes, who published

“The problem of weather prediction”,

an academic paper describing the circu-

lation of masses of air. If you knew the

density, pressure, temperature, humid-

ity and the velocity of the air in three

dimensions, and plugged the results

into Bjerknes’s formulas, you would be

on the way to a respectable weather

forecast — if only you could solve those

computationally-demanding equations.

The processing power to do so was to

arrive many decades later.

The missing pieces, then: much bet-

ter, more detailed and more frequent

data. Better theory too, perhaps —

although it is striking that many cri-

tiques of the economic mainstream

seem to have little interest in high-reso-

lution, high frequency data. Instead,

they propose replacing one broad

theory with another broad theory: the

latest one I have seen emphasises “the

energy cost of energy”. I am not sure that

is the path to progress.

The weather forecasters have another

advantage: a habit of relentless

improvement in the face of frequent

feedback. Every morning’s forecast is a

hypothesis to be tested. Every evening

that hypothesis has been confirmed or

refuted. If the economy offered similar

daily lessons, economists might be

quicker to learn. All these elements are

linked. If we had more detailed data we

might formulate more detailed theories,

building an economic map from the bot-

tom up rather than from the top down.

And if we had more frequent feedback,

we could test theories more often, mak-

ing economics more empirical and less

ideological.

And yet — does anyone really want to

spend a billion pounds on an economic

simulation that will accurately predict

the economic weather next week? Per-

haps the limitations of economic fore-

casting reflect the limitations of the eco-

nomics profession. Or perhaps the prob-

lem really is intractable.

[email protected]

Economists can learn

a lot from meteorologists

Every morning’s forecast is

a hypothesis to be tested.

Every evening it has been

confirmed or refuted

Tim

Harford

The undercover

economist

I

recently asked some investment

managers how they might immu-

nise their portfolios against fallout

from China’s coronavirus. “I

wouldn’t,” one scoffed, “the virus is

temporary.” Another rattled off some

ideas but added “no one is actually posi-

tioning their portfolio that way”.

Investors have been conditioned to

believe that disturbances such as mad

cow disease, Sars, and now the coronavi-

rus are temporary blips. Even if that

proves to be correct, interruptions to

global supply chains may cause greater

problems for growth and markets than

investors are expecting.

Signs of complacency about the coro-

navirus abound. According to Bank of

America’s February global survey of

fund managers, cash comprises only 4

per cent of portfolios, the lowest since

March 2013. When investors are wor-

ried, they tend to hold more cash.

Instead, they’ve been putting their

money into global equities, which keep

hitting record highs.

Investors appear to view the corona-

virus like a minor traffic jam: disruptive

but, in economic and financial terms,

something you get past quickly. They

are making two assumptions. First, the

coronavirus will be contained shortly,

pent-up demand will be released and its

impact is therefore transitory. Second, if

the epidemic isn’t contained quickly,

policymakers will step in to fix the mess

with actions that send asset prices soar-

ing. Either way, buy the dip.

Chinese authorities are already

throwing the proverbial kitchen sink at

their economy. The Ministry of Finance,

People’s Bank of China, and regulators

have all announced measures to reduce

the burden for firms and households. If

the drag on growth is sustained or mar-

ket turmoil spreads, investors assume

other central banks will also act.

But what if the coronavirus fallout is

more like sitting in traffic hours after an

accident scene is cleared? Demand may

recover quickly, but the supply side is

much more problematic. Chinese firms

are integrated into complex, global sup-

ply chains and the enthusiasm for “just

in time” manufacturing, which involves

thin inventories, leaves little buffer for

disruptions.

Bottlenecks could develop as produc-

tion ramps back up. Say one of the parts

for your product comes from Hubei, the

province at the centre of the coronavi-

rus. To resume normal activities, facto-

ries must reopen and workers must

travel back to them after being forced by

the virus to extend their Lunar New

Year holiday. More than one-third of

China’s labour force are rural migrant

workers. Then truck drivers must trans-

port goods to the coast and ports must

reopen. If any one of those steps is ham-

pered, the factories might as well still be

at least partially closed.

Large companies will use airfreight

for their parts, but this will eat into mar-

gins. If the supply chain disruptions per-

sist, smaller firms may have to find new

suppliers or risk going out of business.

This isn’t easy; if western firms had a

simple alternative to China for inputs,

the US-China trade war probably would

have led to supply chain shifts already.

Hubei is a cog in global supply chains

in autos, healthcare, electronics, aero-

space and defence and construction

materials. The outbreak has already

pushed South Korean firms Hyundai

and Kia to halt production.

Finally, there is a problem with rely-

ing on policymakers to clean up the

mess. Their tools are designed to

stimulate demand, not fix supply inter-

ruptions. “I’ve only been at the Fed for

two years,” Richmond Federal Reserve

Bank president Tom Barkin told me.

“But to my mind, central banks can’t

come up with vaccines.”

Most investors assume the coronavi-

rus will be contained by late March and

that, as winter ends, so will the epi-

demic. But we cannot be sure the out-

break has a natural peak. If the virus

becomes a full-blown global pandemic,

growth and markets will be hit much

harder than investors are assuming.

So what can you do? While there’s

much we don’t know about this disease,

we do know it has increased uncer-

tainty, and if you think it may be worse

than Wall Street is wagering, there are

cheap ways to insure against a market

decline. Uncertainty tends to breed vol-

atility, so one strategy is to buy the Vix

index, which goes up with volatility.

Another is to buy the Skew Index, which

focuses on options that make money if

there is a big fall in the stock market.

Another way to immunise your port-

Many appear to view

the outbreak as a minor

traffic jam: disruptive,

but easily bypassed

folio is to invest in safe haven assets,

including the US dollar, Treasuries and

precious metals. Prices for these assets

have risen over the past two months, but

they could go higher still if investors

decide their wait-and-see approach is

wrong. Consider shorting the Japanese

yen, traditionally a safe haven asset,

given the country’s high exposure to the

coronavirus.

If you want to stay in equities, look to

utilities, internet, education and — no

surprise here — healthcare. Sectors to

short include commodities, particularly

oil, airlines, entertainment and luxury

goods. Investors may be right that this

will be temporary. If your time horizon

is several years, then it could make sense

to look past the coronavirus. But tempo-

rary can last a long time and get much

worse before it gets better. For shorter

horizons, remember that there are effec-

tive vaccines for your portfolio that

sadly do not yet exist for the virus itself.

The writer is a senior fellow at Harvard

Kennedy School

Investors risk underestimating the impact of coronavirus

FINANCE

Megan

Greene

FEBRUARY 22 2020 Section:Features Time: 21/2/2020 - 18:17 User: alistair.hayes Page Name: COMMENT, Part,Page,Edition: LON, 11, 1