Stocks in emerging markets have had a rough year — but that could change considerably next year, Morgan Stanley said in its Global Strategy Outlook report for 2019.

The projected turnaround for emerging markets is one reason why the investment bank prefers stocks in those economies over that of the U.S. next year. Morgan Stanley said it upgraded emerging market stocks from "underweight" to "overweight" for 2019, while U.S. equities were downgraded to "underweight."

"We think the bear market is mostly complete for EM," the bank said in the report dated Nov. 25, implying that stocks in the emerging markets may soon rise. "We are taking larger relative positions and adding to EM."

Many investors withdrew from emerging markets throughout 2018 and bought more assets in the U.S. due to a spike in bond yields and the appreciating greenback. At the same time, financial troubles in countries such as Turkey and Argentina were escalating — giving investors more reasons to sell their holdings in emerging markets.

As a result, the MSCI Emerging Markets Index — which measures stocks in 24 economies — has fallen by around 16 percent so far this year. But in Morgan Stanley's base scenario, the index is expected to rise 8 percent by December 2019 from current levels — outperforming the 4 percent forecast for both the S&P 500 and MSCI Europe Index.

Morgan Stanley prefers stocks in emerging markets to those in the U.S. because it is predicting stable growth in those economies in 2019, versus a slowing expansion stateside.

The bank expects U.S. growth to moderate from the 2.9 percent estimates this year to 2.3 percent in 2019 and 1.9 percent in 2020. Such a slowdown will likely dent the outlook for the greenback, which will provide some breather for emerging markets with large amounts of debt denominated in the U.S. dollar.

In comparison, growth across emerging markets has been forecast to slow slightly from 4.8 percent this year to 4.7 percent in 2019, before inching back up to 4.8 percent in 2020, Morgan Stanley said in its report.

Where to put your money in 2019

Within the emerging markets space, Morgan Stanley said its key "overweight" countries are Brazil, Thailand, Indonesia, India, Peru and Poland. The bank is "underweight" Mexico, the Philippines, Colombia, Greece and the United Arab Emirates.

The bank also prefers what's known as "value stocks" over "growth stocks" globally. Value stocks refer to listed companies that are trading at a price below where some think it should be, while growth stocks are firms that are seen to have a lot of potential to grow.

"We find that value stocks are concentrated in financials, materials, energy and utilities (in that order)," said Morgan Stanley. The bank added that it has an overweight stance on all those four sectors, and "a negative sector bias in tech, healthcare and consumer."

Another investment idea that the bank highlighted in its report is an overweight in metals and mining firms, which are "experiencing secular support for its earnings power."

'Three overarching headwinds'

Despite the potential for higher returns in stocks, especially in emerging markets, Morgan Stanley said it is not overly excited about stocks overall.

The bank maintained a "neutral" stance on the asset class for 2019. The bank is also neutral on government bonds, underweight on credit and overweight on cash.

Morgan Stanley cited "three overarching headwinds" that are "limiting our enthusiasm for equities overall."

First, there are "predominant" downside risks to global growth in 2019, the bank said. Secondly, potential growth in company earnings have weakened significantly globally, especially in China and Europe.

Finally, the report said, companies could face pressures from rising wages and financing costs, which would limit growth in their earnings-per-share.

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