Citi Sees Big Turnaround for Emerging Market Stocks

Tomohiro Ohsumi | Bloomberg | Getty Images

Emerging market equities have taken quite a beating in the last couple of months on fears of the U.S. withdrawing its monetary stimulus, but Citi says investors are too bearish on the asset class, and they're predicting a big turnaround.

The bank's bullish outlook calls for a nearly 27 percent upside to the MSCI Emerging Markets Index in the next 12 months to 1150 from the 907 level on Monday.

"Our main reasons for optimism: consensus is too bearish/underweight emerging markets, liquidity is ample, economic surprises are improving, earnings are outperforming developed markets, and valuations look cheap," Citi said in a note.

(Read More: Emerging Market Stocks at Their Cheapest This Year: Citi)

Citi's index target is based on one year forward price to earnings (P/E) ratio of 12.4 versus the post 1995 average of 15.

"On price to book value, this equates to an exit multiple of 1.7 times, a 10 percent discount to the historic mean," Citi said.

The MSCI Emerging Markets Index is down almost 13 percent since late May when U.S. Federal Reserve Chairman Ben Bernanke failed to provide a clear picture on the continuation of its monthly $85 billion bond buying program, sparking fears of tapering.

(Read More: Emerging Markets Allocations Lowest Since 2008)

Emerging market currencies, equities and bonds have benefitted from the Fed's loose monetary policy, which has pumped extra liquidity into the region's financial markets.

Citi says central banks' balance sheets in this group of countries should provide ample liquidity amid concerns over capital inflows as the Fed tightens.

"In aggregate, the balance sheets of the GEMS (growth emerging markets) central banks are still expanding by 6.1 percent on a year-on-year basis," Citi said. "A strong relationship exists between the growth rate of the asset side of central banks' balance sheets and price to book valuations. Expand the central banks' balance sheets and price to book valuations follows."

Within emerging markets, Citi is overweight Asian countries over the Middle East and Latin America with a preference for China, South Korea and Taiwan in the region.

(Read More: After Selloff, Some Dip Toes Back Into Emerging Markets)

"Asia screens much better when it comes to value and has better earnings per share revisions/price momentum than either of the other two regions," Citi said. "In terms of financial stability Asia also ranks better than Latin America."

In terms of stock picks, the bank recommends being overweight consumer discretionary, financial and technology equities on improving global growth over consumer staples, healthcare and utilities.

(Read More: Emerging Market Growth Hits Lowest Since Financial Crisis)

"Overall, we have a value tilt to our portfolio, but also a growth tilt as the overweight markets benefit from improving global growth. Improving leading economic indicators and a steeper yield curve suggest that the global economy is slowly getting better," the bank said.

- By's Rajeshni Naidu-Ghelani; Follow her on Twitter @RajeshniNaidu