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In light of higher expected volatility, I’ve been advocating investors take a defensive stance in equities for months. However, my view on which markets are defensive vs. which are risky is shifting.

Traditionally, investors looking for more defensive country-specific exposure would have opted for equities of developed world countries, while the stocks of emerging market countries would have been considered more risky options. However, lately I believe many emerging market countries have actually become more attractive places to invest than parts of the developed world, and that’s partly why I recently ended my preference for developed markets over emerging markets.

Why are some emerging markets now more attractive? One reason is that certain countries within the developed world are at the epicenter of the recent global sovereign debt crisis. In fact, as I’ve mentioned before, many of the emerging markets that were viewed as dangerous even 10 years ago now appear to be pictures of fiscal rectitude, particularly in comparison to much of the developed world.

In addition, a number of developed market countries tend to be the ones with the most concerning slowing growth. And in the current economic environment, I tend to prefer economies that are driven mostly by domestic demand and are thus isolated from some of the slowing global growth trends. Many emerging market countries fit this bill.

Like me, the broader market also appears to be shifting its perception of which markets are risky. One way of gauging investors’ perceptions of the riskiness of a country’s stock market is to look at how risky the country’s debt is, as measured by sovereign credit default swap (CDS) spreads. CDS spreads measure the cost of insuring against the possibility that a country will default on its debt, i.e. they are a measure of the extent to which a country has sovereign debt problems. The wider a country’s CDS spreads, the more likely the market thinks that country will go bankrupt, and the more nervous the market is about that country.

Based on my analysis, over the last year and a half the market has increasingly viewed certain developed market countries as riskier than emerging markets, with some developed markets actually viewed as likely to go bankrupt. At the same time, emerging market countries overall have become increasingly perceived as safer.

For instance, from January 2010 to July 2011, the average five-year CDS spread for developed market countries in the MSCI ACWI index increased 206% to 263 basis points (bps), while the average spread for emerging market countries actually decreased by 9% to 132 bps. At the end of January 2008, in contrast, the ten developed world countries for which such data was then available had CDS spreads of less than 45 bps and were all among the 11 countries perceived to the be the least risky. At that time, Indonesia, the Philippines and Turkey were considered the riskiest countries.

Currently, while the spreads for most developing markets are widening, Portugal, Italy, Greece and Spain are much to blame for the widening developed market CDS spread. The average spread for these four countries increased 332% to 822 bps from January 2010 to July 2011.

Such countries in the eurozone periphery are now considered risky places to invest, with the CDS spreads of these countries considerably higher than those of most emerging market countries. And in today’s economic environment, where sovereign debt concerns and related politics are for the most part driving the eurozone periphery markets, both the stock markets and the CDS spreads of these countries are moving in lock step, another sign of their shared risks.

To be sure, the riskiness of a nation’s sovereign debt is correlated with, though not exactly the same as, the riskiness of a country’s stock market. But other measurements of perceived risk, including how much a country’s valuation shifts with investors’ appetite for risk, also show that certain emerging markets are likely to be less affected by today’s uncertain environment than parts of the developed world.

More importantly, not all developed markets are currently perceived as highly risky. For example, core eurozone economies such as Germany and the Netherlands still have relatively narrow CDS spreads, even if somewhat wider than a couple of years ago, and we currently see good value in these markets.

According to my analysis, over the past couple years, the developed market world has polarized into countries perceived as especially safe and countries perceived as especially unsafe. In the middle level of perceived riskiness, you now find emerging markets.

What does this mean for investors? In any regional allocation, investors should consider reexamining the traditional developed vs. emerging markets country classification and focusing instead on how sub-regions or individual countries are likely to trade today amid so much economic and political turmoil.

Source: Bloomberg

Disclaimer: In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country may be subject to higher volatility.

Source: Emerging Markets: The New Defensives?