At the trading desks in Sao Paolo, Brazil, you can hear a collective sigh of relief.

The country’s Bovespa market index, which had fallen roughly 30% over the two years ended March 1, has finally reversed course.

Since early March, this index has rallied more than 10% to above 51,000, boosting the prospects of a range of long-suffering exchange-traded funds (ETFs).

#-ad_banner-#Before you can conclude that you’ve missed out on this impressive mini-rally, know that these funds remain far below their multi-year averages. That last ETF, for example, the ProShares Ultra MSCI Brazil ETF (NYSE: UBR), has rebounded from $32 to $48, but stood above $140 back in 2011. Most of these ETFs trade for less than half of what they traded for back then (though some were launched since then).

The real questions are: What’s driving this rebound, and what does it mean for Brazilian stocks for the rest of the year and beyond?

The End Of Rate Hikes
Brazil’s economy has been throttled by rising interest rates as the government works to halt the advance of inflation, which recently reached 6%. But the cycle of higher rates may be nearing an end. The current benchmark 11% interest rate may move a tick higher at the next meeting of the Brazilian central bank, but that should mark the end of the rate cycle. 

Brazil’s woes over the past few years can also be attributed to high levels of consumer debt that have curtailed spending. More recently, a widespread drought is hurting crop yields and may lead to power blackouts as hydroelectric-power systems lack sufficient water.

Even with the expected boost from the upcoming World Cup games, Brazil’s economy is expected to grow less than 2% this year, a far cry from 2010, when GDP growth exceeded 7%. Against such a bleak backdrop, the recent rally is surely curious. Yet a pair of explanations help clarify matters.

First, there had been concerns that China’s economy would slow, cutting demand for Brazilian exports. The Chinese government has recently signaled a willingness to provide fresh economic stimulus, helping many commodities and emerging markets to stabilize.

Second, even with many headwinds, the Brazilian economy has some clear positives. Unemployment remains near the lowest levels seen in the modern era, and thanks to certain government actions, wages have risen sharply. As a result, Brazilian consumer spending is expected to start to rebound in coming quarters, especially as interest rates aren’t expected to move much above current levels.

Perhaps the simplest explanation for this rally is that Brazilian stocks are very inexpensive, as is the case with many emerging markets. 

Let’s take at the Market Vectors Brazil Small-Cap ETF  (NYSE: BRF) as an example. According to Morningstar, the portfolio’s typical holding is valued at 1.1 times book value, 0.64 times trailing sales and 6.4 times cash flow. While U.S. stocks trade for a similar 7 times trailing cash flow, they also sport price-to-book and price-to-sales multiples that are more than twice as high as this Brazilian fund.

That valuation disconnect makes sense. After all, over the past two years, the S&P 500 has risen 40% while this Brazilian ETF has fallen by a similar amount.

If the backdrop of full employment and rising wages leads you to expct a rebound in consumer spending, then this is the perfect ETF: 37% of the portfolio is invested in consumer discretionary and defensive stocks, while another 18% is invested in real estate firms.

Speaking of that sector, Brazilian homebuilder Gafisa (NYSE: GFA) remains a favorite way to play the Brazilian consumer class. I profiled this company roughly six weeks ago on our sister site, ProfitableTrading.com, and though shares have risen 30% since then, they still have more than 50% upside to my $5.25 price target. 

Risks to Consider: The biggest risk for Brazil — or any other emerging market — remains China. Rightly or wrong, investors believe that a further slowdown in China would deal a tough blow to export-led economies such as Brazil. So be prepared for fresh dips in any of these investments if China wobbles.

Action to Take –> To an extent, a focus on the rebound prospects for Brazil in 2014 obscures a broader point. Despite serious near-term economic headwinds, Brazil is blessed with vast natural resources, an increasingly well-educated workforce, and a massive export opportunity into the rest of Latin America and elsewhere. This is a country built for the next decade or two, not the next year or two. The fact that shares prices remain multi-year lows, despite a recent mini-rebound, simply underscores the growth and value proposition. 

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