Nov. 10 (Bloomberg) -- Emerging-market stocks are poised to gain 25 percent by the end of next year, for the steepest two- year rally since 1989, as earnings surge and investors boost holdings in the fastest-growing economies, Morgan Stanley said.

The MSCI Emerging Markets Index is likely climb to 1,200 by the end of 2010, Jonathan Garner, the chief Asia and emerging- market strategist at Morgan Stanley in London, wrote in a research report. The forecast amounts to a 25 percent advance from yesterday’s closing level and a 112 percent surge since the end of 2008, according to data compiled by Bloomberg.

“Commodities, the dollar and the Chinese economy are all broadly moving the right direction,” Garner, who predicted this year’s rally in developing-nation stocks, said by telephone from London. “We like China and we like buying financials, banks, insurers, real estate and consumer discretionary stocks in India, Brazil and Indonesia.”

Russian stocks jumped the most in more than three months yesterday, while Chinese equities extended an eight-day winning streak today, the longest in more than two years, after the Group of 20 nations said they will maintain economic stimulus.

‘Major Peak’

“Economies and earnings are recovering,” Garner, wrote in the report. “It is likely too soon in the cycle for a major peak in emerging-market equities.”

The MSCI gauge of 22 developing nations rose 0.4 percent to 963.09 as of 5 p.m. in New York. The 22-country measure has increased 6.6 percent since Nov. 3, the sharpest five-day advance since July.

Developing-nation bonds rose today, sending the extra yield investors demand to own the debt over U.S. Treasuries down five basis points to 3 percentage points, according to JPMorgan Chase & Co.’s EMBI+ Index. Most emerging-market currencies fell against the dollar, led by a 0.8 percent drop in Brazil’s real.

Morgan Stanley’s Garner raised his forecast for 2010 profit growth in emerging markets to 40 percent from a previous estimate of 28 percent, according to the report dated Nov. 9. The strategist said China is his biggest “overweight” recommendation and his preferred industry is energy, along with financial and consumer companies in “under-levered, faster- growing economies” including Brazil and India.

‘Underweight’ South Africa

South Africa has the largest “underweight” recommendation for countries, while Garner’s least favored industries are telecommunications and utilities. He downgraded technology companies to “equal-weight,” citing valuations and the industry’s “sensitivity” to interest-rate increases.

Many Asian central banks may begin raising borrowing costs in the first quarter of 2010 and the U.S. Federal Reserve will likely increase rates in the third quarter, Garner wrote. Tighter monetary policy, along with rising oil prices, are “headwinds” that may slow the pace of gains for emerging- market equities, he wrote.

Crude oil has surged 78 percent this year to $79.48 a barrel. Prices may average $85 a barrel in 2010, $95 a barrel in 2011 and $105 a barrel in 2012, according to Morgan Stanley forecasts.

Emerging-market shares may get a boost as managers of global equity funds allocate more of their holdings to developing nations, Garner wrote. Global funds have an average 8.9 percent of their holdings in emerging markets, compared with a benchmark weighting of about 12 percent, Garner wrote.

The MSCI emerging index has rallied 69 percent this year, compared with a 26 percent increase in the MSCI World Index of developed-country stocks.

Global Funds

“Outperformance by emerging markets versus developed markets this year should lead global equity funds to reassess their structural underweighting of emerging markets,” Garner wrote.

Garner’s outlook for gains in emerging markets is shared by Arnab Das, the London-based head of market research and strategy at Roubini Global Economics. Das said in a Nov. 3 interview that investors should hold “overweight” positions in developing- nation assets as the so-called carry trade fuels advances in stocks, bonds and currencies in emerging markets.

“This flow of capital into emerging markets is based on better fundamentals for the near term than” advanced economies, Das, the former head of emerging-markets strategy at Dresdner Kleinwort, said in the interview. In a carry trade, investors borrow in countries with low interest rates to invest in higher- yielding assets.

To contact the reporter on this story: Michael Patterson in London at mpatterson10@bloomberg.net; Shiyin Chen in Singapore at schen37@bloomberg.net.

Last Updated: November 10, 2009 17:23 EST