SINGAPORE:  Chinese stocks may extend their 2009 gains and peak next year as the nation’s accelerating economic growth combines with low inflation and interest rates to create a “Goldilocks situation,” Morgan Stanley said.

The economy may expand 10% next year, helping companies on the MSCI China Index to increase earnings by 25.5%, Morgan Stanley analysts led by Jerry Lou wrote in a report dated yesterday. The rally will probably end next year, they said.

“Accelerated growth, early stage inflation and late policy exit could together create a temporary ‘Goldilocks’ in China, which is bullish for equities,” the analysts said, referring to the fairy tale. There may be an “upward re-rating” in valuations from “current fair levels as earnings accelerate,” they added.

The MSCI China, a measure of the nation’s shares traded in Hong Kong, has gained 62% this year, while the Shanghai Composite Index, tracking the larger of China’s two stock exchanges, has gained 74%. The equities have rallied as the government’s 4 trillion yuan ($586 billion) stimulus package spurred fixed-asset investment, loan growth and retail sales.

The MSCI China index is valued at about 16.7 times its 2009 earnings and about 13.9 times next year’s estimated profit, making the market “undemanding and cheap,” the analysts said. Multiples are likely to increase next year, they said. The gauge was little changed at 66.16 as of 10:54 a.m. in Hong Kong.

China’s gross domestic product grew 8.9% in the third quarter, the fastest pace among the world’s major economies. The government has said it’s targeting an expansion of 8% for 2009.

Low Rates

Inflation measured by the consumer price index will probably average 2.5% next year, signaling “low” interest rates next year, according to the report. Wang Qing, the brokerage’s chief Asia economist, doesn’t expect the central bank to raise rates before the second half of 2010.

Investors should be “overweight” in consumer, insurance, Internet, media, telecommunications and energy stocks, while avoiding banks, property and materials companies, the analysts said. Cnooc Ltd., China’s largest offshore oil explorer, is the largest holding in Morgan Stanley’s China model portfolio.