Morgan Stanley has been buying back holdings in global emerging markets and has raised its equities weighting to a 6% overweight from a previous 2% overweight. ThatÆs its biggest upgrade for that market since August 2007.

The upgrade is based on scenario analysis, current valuations, and a range of other tactical indicators. Morgan Stanley has also closed its underweight position on hard currency emerging market sovereign debt, where it is now neutral. The firmÆs large emerging markets equities overweight is now funded by underweights in local currency emerging markets debt (previously neutral) and in cash (previously overweight).

ôWe think the emerging markets equities bull market is intact,ö Morgan Stanley says in an equities strategy report.

The MSCI Emerging Markets Index has given back only 7% of the total return it has generated since January 2003, making valuations ôhighly attractive barring a global stagflation scenarioö, the firm says.

The MSCI Emerging Markets trailing price-to-earnings ratio is around 3.2 times, which is 20% below the post-1992 average and is a 6% discount to valuations of developing markets.

ôBuying emerging markets when trailing P/Es fall below 13.5 times has delivered positive returns 3 months and 12 months out in 100% of the six previous occasions it has occurred in the history of emerging markets,ö the firm says.

Morgan Stanley argues that the core economic decoupling thesis remains intact, but it notes that macro developments in the first half of 2008 were a surprise. In a November 2007 outlook piece, the firm outlined four scenarios (bubble, bull, base, bear) for 2008. It pointed out that these scenarios were not mutually exclusive and the real world would likely combine elements of more than one of the scenarios. However, it did not expect to see elements of all four scenarios, from bubble (commodity prices) to bear (emerging markets sovereign spread widening) in the actual outcome.

ôThe key surprise for us in the first half was the strength of the commodity price increases,ö the firm says, adding it did not expect an acceleration in the pace of price gains, particularly for oil. ôThis led to a major acceleration of headline inflation and caused equity markets to begin to price in a stagflation scenario.ö

Morgan Stanley believes the most likely scenario for the next four quarters is that key developed markets will flirt with, and in some instances actually move into, recession. Growth will also likely slow dramatically in certain vulnerable emerging market countries. However, the firm is equally convinced that other geographies, and in particular the core of the emerging markets asset class (Brazil, China, Russia and the Middle East), will come through relatively unscathed with only modest growth slowdowns.