June 18 (Bloomberg) -- Pakistan, wracked by a war with Taliban insurgents and a record current-account deficit, is this year’s best bond investment, according to JPMorgan Chase & Co. indexes. Money managers say the stock market, the region’s cheapest, may be next.

Dollar-denominated debt sold by Pakistan returned 88 percent so far this year, more than any of the 45 emerging markets tracked by New York-based JPMorgan and 19 developed countries followed by Merrill Lynch & Co. Shares in the Karachi Stock Exchange 100 Index trade at 9.5 times reported earnings, the lowest in Asia excluding Japan, after the gauge rose 20 percent in 2009.

Pakistan’s economy deteriorated in the past year as terrorist attacks led investors to sell a net $1.1 billion of stocks in the 11 months ended May 31, compared with purchases of $87.2 million of shares a year earlier, according to the central bank. Government forecasts for 3.3 percent economic growth in the year starting July 1, a bailout by the International Monetary Fund and equities trading near the cheapest levels in at least four years are making the country more attractive.

“The worst is over for the Pakistan markets,” said Tariq Iqbal Khan, who manages the equivalent of $865 million in stocks as chief executive officer of government-owned National Investment Trust in Karachi, the nation’s biggest money manager. “Values are so good at the moment because the sentiment was so over-depressed. I see some buoyancy returning to the market.”

MSCI’s Removal

Just six months ago, MSCI Inc., whose indexes are tracked by money managers with $3 trillion of assets, removed Pakistan from its emerging-market gauge, citing a “near total paralysis” in trading.

The Karachi bourse had imposed limits on daily price swings after investors stoned the exchange and smashed windows to protest declines in share prices.

Pakistan has been hit by more than 25 bombings since the military began a campaign against insurgents in the northwestern Swat Valley seven weeks ago. Authorities say many were orchestrated by Pakistani Taliban commander Baitullah Mehsud and troops have expanded their offensive into the South Waziristan tribal district where his forces are based. The army moved in after the Taliban advanced to within 100 kilometers of the capital, Islamabad.

‘Short of Everything’

Pakistanis in a northwestern region devastated by fighting between the Talibans and security forces are “short of everything” and in urgent need of assistance, the International Committee of the Red Cross said in a statement yesterday.

The government said last week it won’t meet its budget- deficit target as spending to fight insurgents increases.

Pakistan was forced to turn to the IMF in November after foreign reserves shrank by 75 percent, the current-account deficit widened to a record and inflation soared to a three- decade high.

While South Asia’s second-biggest economy may accelerate from 2 percent growth in the past year, it will expand at less than half the average annual pace of 6.8 percent over the preceding five years.

The budget gap for the year starting July 1 is estimated at 4.9 percent of gross domestic product, the government said on June 13. That breaches the 4.6 percent goal set by the IMF as part of its $7.6 billion bailout.

‘Concerned’

“I’m concerned the budget and political problems are too big at the moment,” said Stefano Costagli, an emerging-market fund manager at San Miniato, Italy-based Vegagest SGR SpA, which manages the equivalent of $2.5 billion. “I don’t like countries that rely too much, or too long, on that support.”

Declining interest rates and slower inflation will help boost stocks, National Investment’s Khan said. He expects the benchmark interest rate, now at 14 percent, to fall by at least 2 percentage points next month. Inflation may slow to less than 10 percent from 14 percent over the next two to three months, according to Khan.

“We’re not seeing a major turnaround in the economy but as interest rates come off, that’s when you will see genuine interest coming back to stocks,” Nasim Beg, who helps manage the equivalent of $160 million at Arif Habib Investments Ltd. in Karachi, said in an interview today. “So we expect good upside for stocks.”

‘Strong Positive Stimulus’

Beg, whose Pakistan Stock Market Fund doubled in the past five years, is the best performer among 29 funds that invest in the country’s equities, according to data compiled by Bloomberg. He estimates the stocks in his funds are 30 percent less than their fair value, declining to name individual companies.

Citigroup Inc. said in a report June 15 that Pakistan is too reliant on foreign funds and lacked “strong positive stimulus,” which may limit gains. The Karachi index has gained 2.8 percent for the quarter, the worst performance in Asia, according to data compiled by Bloomberg. The measure fell 0.3 percent to 7,051.77 at the close.

Aberdeen Asset Management Plc in London is bullish about Pakistan because the country is a beneficiary of international support. The U.S. House voted on June 11 to triple economic and development aid and to increase military assistance to stabilize a country vital to the war in neighboring Afghanistan.

“We are positive,” said Edwin Gutierrez, who helps oversee $4.5 billion of global emerging-market debt at Aberdeen Asset Management Plc in London and added Pakistan dollar bonds to his funds earlier this year. “It was pretty clear that the international community is supporting Pakistan and providing it with a decent amount of money.”

To contact the reporters on this story: Pooja Thakur in Mumbai at pthakur@bloomberg.net; Lilian Karunungan in Singapore at lkarunungan@bloomberg.net.

Last Updated: June 18, 2009 07:09 EDT