Daily Commentary

MarketMinder’s View: This piece takes a procedural change at some S&P 500 index funds and runs it to a weird place. In doing so, it mentions several funds and companies, so bear in mind MarketMinder doesn’t make individual security recommendations and features this for the broad theme only. That theme: Because some of the huge “Magnificent Seven” Tech and Tech-like companies now represent such a large index weight, S&P 500 index funds no longer meet regulatory criteria for being diversified, requiring them to reclassify as “nondiversified funds,” which in turn allegedly means the index “isn’t as safe as it has been for more than 50 years.” We see some problems with this, chief among them: No stock market is ever “safe.” Ever. All stocks, big and small, carry the risk of loss. And having lower stock concentrations in the past didn’t prevent the S&P 500 from losing almost half its value during the 2000 – 2002 bear market or even more than that in 2007 – 2009’s downturn. That … that is not safe. “Safe” doesn’t exist. And as for the observation that investing in US stocks alone isn’t sufficient for diversification, we reckon that has always been true, given there is a whole big global stock market. Investing internationally has always been crucial to mitigate country-specific risks and widen your opportunity set, as well as to gain exposure to sectors and industries with relatively less representation in the US. Now isn’t different.

MarketMinder’s View: Is mark-to-market accounting coming to private credit funds in the UK? The reporting here, which comes from unnamed financial industry sources, suggests regulators are eyeing it up, if not via official change then by very strong encouragement. “Officials from the Financial Conduct Authority have in recent weeks been piling pressure on so-called shadow banks – an increasingly critical source of funding for the speculative AI boom – to more rigorously mark down the value of loans that are at risk of not being repaid in full. … Critics of the shadow banks have accused them of ‘mark-to-myth’ valuations that readily account for unrealised gains but rarely take hits even as a loan is obviously turning bad. This is in contrast to ‘mark-to-market’ accounting, which is seen as more transparent and rigorous but can mean unwanted turbulence for investors.” We have seen this movie before, and it didn’t go well. The US adopted a mark-to-market accounting rule in 2007 and applied it to illiquid assets that banks intended to hold to maturity. There were few price reference points for comparable securities available. The result: When hedge funds had to sell similar securities at fire-sale prices, all banks had to take corresponding writedowns, leading to a vicious cycle of forced selling and paper losses. That destroyed bank capital and transformed about $200 billion of US loan losses to over $2 trillion in exaggerated writedowns, per former FDIC chief William Isaac’s math, causing 2007 – 2009’s global financial crisis. Regulators eventually changed the rule, allowing banks to put mark-to-market valuations for hold-to-maturity assets in footnotes instead of letting them affect capital levels, and that system has worked pretty well for 17 years. Applying mark-to-market rules to private credit funds, however well intended, risks restarting that chain reaction in the private asset world, which could quickly force investors to sell more liquid securities to cover unexpected paper losses. So far, there isn’t a significant transmission mechanism linking private equity and credits’ troubles to traditional markets. But this potential change deserves very close scrutiny and is a risk to watch. 

MarketMinder’s View: This is a pretty balanced take on the implications of Venezuela’s new bill opening its oil sector to private and foreign investment. “The new law stipulates that even when they are minority partners in joint ventures with [state-run Petróleos de Venezuela] PDVSA, private companies may exercise ‘technical and operational management’ directly, breaking with the previous rule that required state control over operational decisions. It also provides for a possible reduction in royalty payments to the regime from 30% to zero.” In exchange, the US has loosened some of its sanctions on the industry. While politicians in the US and Venezuela claim this will jumpstart investment and production, as the article explains, this might be a hasty conclusion as the new law “‘fails to address all the causes that led to the collapse of the oil sector.’” Corruption under the current regime is a biggie, as is the fact that the “legislature” is stacked with regime loyalists. Laws passed quickly under those conditions can be changed and revoked quickly, which extends uncertainty. Without clarity on the long-term political situation, firms may remain reluctant to take much risk. And even if they do, amping up output much is a yearslong project. From the start, we thought hopes for a rapid production increase were far-fetched. This is more evidence supporting that. For more, see our recent commentary, “Viewing Venezuela Through a Market Lens.”