* Performance within emerging Europe to diverge further
* Contagion risk reduced as country fundamentals emphasized
* Borders between developed, emerging Europe to blur further
By Sebastian Tong
LONDON, Dec 16 (Reuters) - Lumped together for much of the initial plunge and subsequent recovery of 2009, emerging European markets will likely see greater discrimination from investors next year and, for all the caveats, some may even outpace euro zone counterparts.
Disparities within central and eastern European markets will sharpen in 2010 not least because the driver of market herding over the past 18 months -- the dash for and then wholesale exit from safe-haven cash funds -- is likely to be exhausted.
That leaves investors to concentrate more on idiosyncratic, country-specific risk, which abounds in a region where several countries remain on IMF and EU life support while others have maintained growth throughout a year of turmoil.
"One of the characteristics of this financial crisis is that the markets all went down together. They subsequently rebounded together. But going forward, we're going to see a lot more divergence in markets and economic prospects," said Rekha Sharma, global strategist at JPMorgan Asset Management.
In the overall global rebound in risk, Europe has trailed Asia and Latin America in attracting returning capital, with European equity funds attracting half of the amount that went into China-focused equity funds.
The MSCI central and eastern Europe price return index, which includes Russia and CIS states has fallen over 40 percent this year, compared to gains of over 70 percent for the benchmark MSCI emerging stock index.
But regardless of that, some countries have stood out. Russia's stock market, for example, was one of the top five in the world in 2009. Hungarian local debt also generated some of the best fixed income returns this year as the debt market restarted trading after a total collapse in 2008.
"There are surprising stories within the region. Compared to other parts of the world, emerging Europe has been ignored and that creates opportunities because valuations are cheap," said Sam Vecht, a fund manager at BlackRock.
Prospects for IMF-recipients economies such as Romania and Ukraine remain clouded but analysts expect Turkish and Russian markets to pull ahead next year.
Polish and Czech markets are also expected to be supported by a Western European economic recovery which has so far proved quicker than expected.
MORE UNDERSTANDING
Meanwhile, rising concerns over the deterioration of public finances of common-currency members such as Spain and Portugal will further blur the lines between emerging and developed European markets.
In the midst of a sell-off that has hit the debt of most of the euro zone's most vulnerable economies, some analysts are pointing to relatively lower debt burdens in central Europe that make countries like Poland or the Czech Republic more stable long-term bets.
Greece's parlous fiscal state has already led to a credit ratings downgrade that has pushed the cost of insuring Greek debt higher than those for non-EU members Turkey and Russia.
Even with the implicit backing of the European Central Bank and a higher credit rating, Greece's benchmark 10-year bonds are trading 150 basis points worse off than comparable debt issued by the Czechs.
Poland boasts a far healthier government debt-to-GDP ratio than core EU members Italy and the UK, as does Romania, even if it is burdened by doubts over further IMF support.
"The market has become more understanding...There's definitely more willingness now to compare developed countries with emerging economies which I think is rational and sensible," said Kaspar Bartholdy, managing director emerging markets at Credit Suisse.
This could go some way to insulating stronger eastern European economies from contagion arising from weaker peers.
At the height of the crisis, the region was punished as a whole whenever investor worries over individual countries such as Latvia and Ukraine flared.
Fears over the stability of Latvia's currency pegknocked eastern European currencies lower and nudged sovereign debt insurance costs higher in June but the recurrence of such concerns in October had a much more muted effect.
But the diminished divide between Western Europe and the former socialist bloc could push non-EU emerging European borrowers to pay more to borrow next year, when total emerging-market debt issuance is expected to outstrip this year's record of an estimated $200 billion.
"There is an implicit guarantee on debt issued by EU members. As an investor, you would ask yourself whether Greek credit looks too cheap compared to that of non-EU members," said Gyula Toth, EMEA economist and strategist at UniCredit.
(Reporting by Sebastian Tong; editing by Patrick Graham)