Investor Notes: BRICs and Credit Default Swaps

A couple of notes from the lunch I went to this afternoon put on by Natixis Asset Management:

•Ron Holt of Hansberger Global Investors passed along a provocative datapoint: that the total market capitalization of all Russia's oil companies is now lower than that of Petrobras, in Brazil. Yes, he conceded, Russia has much more political risk that Brazil. But nothing's really changed on that front over the past month. And energy behemoths like Gazprom are probably more insulated from that political risk than most other Russian stocks.

Holt's a big believer in emerging markets generally and in BRICs in particular: he thinks they should, over the long term, trade at higher -- not lower -- multiples than their developed-market counterparts. I asked him why, then, they had suffered even more than the US during the latest sell-off; he said it was due to forced selling. Equities, after all, have stayed liquid even as many other asset classes seized up: they can be sold, so they are sold. I'm not convinced by this explanation, although I suspect it has a grain of truth to it.

•And Chris Wallis of Vaughan Nelson said that it was dangerous to look at CDS spreads as an indicator of credit conditions: "synthetic markets and cash markets bear no relation to each other" any more, he told the assembled journalists, and he blamed the rise of cash-settled single-name CDS contracts.

I asked Wallis if that meant he'd like to see a reversion to physical settlement in the CDS market; he said that would help bring transparency to the credit market, but that it would certainly have adverse consequences as well. Consider jet fuel: the only reason that any jet-fuel suppliers are still providing fuel to airlines like United and Delta, he said, was that they can hedge the risk they don't get paid in the CDS market. A less-liquid physically-settled CDS market (remember that jet-fuel suppliers don't own United bonds) could have some nasty real-world effects.

I do think that the rise of CDS spreads as credit indicators makes it much harder to tell what's going on in the real world, when the CDS market itself is so rife with speculation and technical factors like the coupons on cheapest-to-deliver bonds. Back when people had to get bond prices to judge such things, you knew the market was illiquid, but you also knew it was much closer to a genuine corporate cost of funds than any numbers we get these days from the CDS market.

Now, of course, with the credit market frozen, the CDS market is all we have. And anybody willing to start lending again is just as likely to start selling credit protection as they are to start buying actual bonds. Which only serves to push back even further any eventual kick-starting of the credit markets.