It’s a small small world

The concept of quantum entanglement suggests that two objects that should be too far apart to affect one another – in fact, due to quantum mechanics – causes one to (instantly) change when the other is affected.   Investors and politicians alike would be wise to be aware of this concept.  Many investors continue to narrowly analyze the US economy without considering many possible worldwide issues and challenges that ultimately could affect the United States. 

For instance, GROUPe des Assurances Mutuelles Agricoles aka Groupama is an international insurance company based in Paris, France.  Groupama’s solvency ratio is extremely weak due to its equity holdings and the state of the global equity markets is in all likelihood not helping.  During a conference call Groupama indicated that that solvency “probably dropped to 117 percent by Aug. 4 from 130 percent at the end of June due to falls in equity markets”.  Global equities have only continued to soften since that conference call.  It is estimated that Groupama will need approximately €2 billion Euro ($1.5 billion USD) of new capital to meet upcoming changes in European capital requirements. 

It is notable that Groupama holds approximately 4 percent (34 million shares) of Societe Generale - France’s second biggest bank, making it the second-biggest shareholder behind employees of the bank.   The share price of Societe Generale (ticker: GLE) has fallen dramatically to $20.87 (Aug 19, 2011) from $41.84(Jan 3, 2011) as there has been persistent speculation that GLE is insolvent; the likely reason why we believe that Groupama has been unsuccessful at selling the bank shares to raise capital to meet the aforementioned new requirements. We estimate that GLE should be valued at less than 40 cents to the dollar of stated book which makes GLE, and by extension the shares, effectively worthless.  What investor would buy an asset that is worth less than its fundamental value?  

If Groupama has solvency issues and GLE is worthless why should US investors care? Or said another way-  aren’t the French financial institutions irrelevant to us? (two objects that should be too far apart to affect one another?).  The answer is not found in quantum mechanics but rather in the global interdependence of financial markets.

In our opinion investors should care because Societe Generale has significant derivative exposure globally and we believe that to avoid some form of systemic financial collapse GLE will likely need to be pulled from the jaws of (financial) death - think AIG in the US.  IF the French government chooses to save Soc Gen, an injection of monies into bank reserves would be needed.  This requires the European Central Bank (ECB) to do what they heretofore have deemed undesirable – print money.  Economics 101 teaches us that adding MORE money to an economy is inflationary and also tends to devalue the currency.  Without getting to far in the weeds, a devalued Euro makes US goods more expensive to Euro denominated consumers.  More expensive goods from a European perspective lead to less purchasing – unless of course you absolutely HAVE to have a Range Rover to drive along the autobahn.  Decreases in US exports will widen the US Trade Deficit. Additionally, after adding to the coffers of GLE maybe the ECB is called on to infuse capital to other troubled sovereign banks – turn on the printing presses! With much more money in circulation the law of supply and demand tells us that the Euro depreciates, but with a number of troubled banking concerns that devaluation could be significant.      

In either case what is the likely US market response? One possible reaction could come from the rating agencies. On August 8^th Moody’s stated in their Weekly Credit Outlook “…a [US] rating downgrade could be triggered before 2013 by … (2) a significant deterioration in economic outlook resulting in adverse fiscal implications that are not offset”.  We submit that a significant widening trade deficit or becoming the recipient of exported inflation is each individually an adverse economic event likely not to be offset, which could trigger a second rating agency downgrade. While this is only one possible scenario that could lead to an increase in rates, we believe that having a second major rating agency downgrade the US would lead to higher interest rates.

You may be wondering what does “significant” actually mean – i.e. how much does the ECB have to crank up the Euro printing press?  What magnitude of bailout funds are we talking about? The Bank of International Settlements estimates that European lenders held approximately $136.3 Billion in loans to Greece at the end of 2010 and nearly $2 Trillion to Portugal, Ireland, Spain and Italy.  We agree with many analysts that put the total sovereign debt in Europe at approximately $6 Trillion—printing and apportioning approximately one-third of total sovereign debt to European financial institutions is clearly significant.

Whatever the breadth and depth of insolvency within the European banking sector turns out to be, one thing is certain - much like physics’ concepts that affect our lives, it would behoove all investors and politicians to remember that there is interdependence among global markets which affects our economic lives daily.  It is a small small world after all.