Pharo’s Mark Dow: Europe to build a fire wall against pigs

Pharo’s Mark Dow: Europe A Possible ‘Fly In The Ointment’
By Olivier Ludwig | May 25, 2010 Page 1 of 2Mark Dow, a trader and strategist at New York-based global macro hedge fund Pharo Macro Fund, cut his teeth in the U.S. Treasury Department and the IMF, where he served as an economist specializing in sovereign debt restructurings. IndexUniverse.com Managing Editor Olivier Ludwig caught up with Dow recently and heard how Dow’s cautious optimism on the U.S. has grown a bit more conditional because of Europe’s economic challenges. The takeaway? Europe can’t squander the precious time the bailout package has given it, and if it does, all bets are off for the world economy.

Things have started to look a bit different now with Greece and everything, haven’t they?

For sure. The fly in the ointment was whether Europe would stumble into some kind of systemic risk, and though it hasn’t happened, the probability of it happening has increased significantly. That was really the main worry on my horizon.

Before, the basic scenario I had was that in the U.S., uncertainties had been reduced, the emerging markets were and are in good fundamental shape, and that Europe was in bad shape, and that they were going to find a way to fund Greece and postpone the restructuring for the foreseeable future. But they dragged their feet so much that it ended up costing them a lot of money.

It reminds me a bit of September 2008 when the House of Representatives initially voted down that bailout bill and the market ended up tanking. There’s an analogy there, isn’t there?

Totally. There are analogies in many respects, and the one that you’re mentioning is that it’s hard to make the case for the virtuous to bail out those who have lived beyond their means. It’s tough to do it in this country; it’s even tougher to do it across different countries.

The other issue is one of French pride—they didn’t want the IMF to get involved, for two reasons. First: the “we can handle our own affairs,” sort of thing; “it makes us look bad.” And second: Strauss-Kahn, the head of the IMF, is a potential socialist rival of Sarkozy in the future presidential election. That’s kind of below the radar, but that’s an issue as well.

France was leaning against the IMF getting involved and Germany was dragging its feet on showing the market the money. We wanted to see it. Because they didn’t [show it quickly], it got worse and worse. That’s what happened. That’s where we are. I think the package the Europeans eventually came out with was good, and they’re kind of in control to some extent of their own destiny, but that doesn’t mean they don’t have a lot of homework to do.

The Wall Street Journal wrote about the market’s pullback last week and led with the point that a lot of hedge funds were pulling some of their optimistic bets on the global economy off the table. Was that on the mark or exaggerated?

A little bit exaggerated, but it also had something to it. In my mind, the chances of a double-dip are very small—unless we get systemic risk from Europe.

So how would the worst-case scenario play out?

The real transmission is through banks if they start having systemic issues, funding issues and things like that. Even if U.S. banks are in much better shape they’re going to be risk-averse for longer, and the dates by which they start lending again to small- or medium-sized enterprises just get pushed out another couple of years. That would have very serious consequences for our rebound here.

You still see this risk as minimal?

It’s not minimal. As the French would say, it’s “non-negligible” for the foreseeable future. Put it this way: By putting the liquidity mechanisms behind Spain and Portugal and agreeing to the modalities of the program in Greece, they’ve taken the market out of the equation for six months to a year or so. Now it’s up to them to get on a path that reestablishes the market’s confidence and their ability to get fiscal solvency, to fix their debt dynamics.

And if they don’t, then all bets are off?

Six months, nine months, a year—you never know when the market is going to react to something, but yes, at some point in the not-too-distant future, if these guys don’t get on credible paths. But Greece is not part of the equation, because they’re probably almost certainly going to end up restructuring anyway. But you want to have that done at a point in time when the firewall between Greece and the other countries has been built and the chance of contagion is minimal.

Pharo’s Mark Dow: Europe A Possible ‘Fly In The Ointment’
By Olivier Ludwig | May 25, 2010 Page 2 of 2What’s your view about the chances of the eurozone shrinking to just Germany, France and Benelux?

In the short term, I think it’s minimal and not very likely. But I wouldn’t be surprised to see Greece leave the monetary union. I think it would be in their best interest to do so, if they can do it in a fashion that minimizes the disorder. Portugal is a tougher call. Spain probably doesn’t need a major overhaul; I think they’ll just muddle through, with Greece being the only constituent that changes. The point to remember is that where we end up is highly path-dependent. It’s really contingent on which kind of decisions are taken, and when they’re taken. If the right decisions are taken at the wrong time, it has a totally different effect on confidence.

Haven’t some of these countries been here before?

Greece has defaulted many times; it’s only recently that they’ve been perceived as being virtuous. We’re seeing a fundamental re-pricing of Europe, really. We’d kind of forgotten credit risk over there, and we’re going to revisit it, and it’s going to stay with us for a while.

As far as the U.S. economy goes, you’re of the mind that things are mending, that the real economy is kicking in?

Fully mending, yes. We’re going to normalize around an anemic rate of growth, but the reduction of uncertainty over time is good. Normalization is good. It’s an unambiguous good, but it’s not spectacular: We will settle into an anemic rate of growth because the credit overhang is going to be with us for a while, particularly in the household sector.

What about the “flash crash” on May 6? Any insight that you’ve culled from the weirdness that day?

A lot of it was technical the way spillover orders flow. In short, in a sell-off, when collars kick in on certain stocks—when they stop trading to cool the system down—some of the market-order flows spill into smaller electronic trading forums. There, they often don’t trade some of these stocks. So if you look at a Level 2 system, where you can see all the bids and asks in particular stocks, and open it up pre-market, you’ll often see there’s a bid at 1 penny and there’s an offer at $999. That’s kind of pro-forma in those systems. It’s just there, so there are bids and offers, but it’s not meaningful. What happened when these flows spilled over was that there were no orders in these other systems. So the prices went all the way down, and those bids at 1 penny were hit. So some stocks were trading at a penny, and there were some stocks where guys were obviously covering shorts, and they hit the $999. You had these really dramatic moves, because these orders spilled over.

Once that happened, once these stocks traded at 1 cent, ETFs had to rebalance, and it hit the stock indices pretty hard, and it knocked people out of their stops. They had all these automated stops in the system, so then it started feeding on itself. I’m not the expert, but that’s my understanding.