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Some of the Brazilian equity market's weakest links could prove the biggest beneficiaries of the country's new investment-grade credit status, market watchers say.

Experts believe Standard & Poor's decision last week to upgrade Brazil's long-term foreign-currency rating to triple-B minus, lifting the country into investment grade for the first time, will lower domestic interest rates and attract increased investment into Brazil - adding fresh fuel to a market that has already enjoyed a meteoric rise in recent years. But they said the traditional drivers of the market - the country's big resource sectors - will probably take a back seat.

"The beneficiaries in the move to investment grade are just those companies that have been underperforming," said Geoffrey Dennis, head of Latin American equity strategy at Citigroup in New York.

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Those would be domestic-focused and interest-rate sensitive stocks, which stand to gain from the lower interest rates that will come from the improved credit profile.

At the top of that list could be the financial sector - which makes up about 18 per cent of the Brazilian equity market. Lower rates should further boost the country's consumer- and commercial-credit businesses, which have already been growing as Brazil's economic stability has improved over the past several years.

Strategists said retailers, airlines and other consumer-centred stocks, as well as companies with high debt loads, should also benefit from lower interest rates.

Many of these stocks have been laggards during the stunning upswing in the Brazilian stock market, which has gained more than 700 per cent since the election of President Luiz Inacio Lula da Silva in 2002 - and almost 19-fold in U.S.-dollar terms. While the country's improved fiscal management, sharply reduced inflation rates, more independent monetary policy and more open investment climate have certainly helped, the boom in commodity prices has become the major driver over the past couple of years.

Much like Canada, Brazil's market is heavily tilted toward resource stocks: The energy and materials sectors make up 60 per cent of the market. Two companies alone - mining giant Companhia Vale do Rio Doce (known commonly as Vale) and energy firm Petroleo Brasileiro SA (better known as Petrobras) - make up 30 per cent of the Sao Paulo Stock Exchange's Bovespa index.

But now, with an increasingly likely rebound in the U.S. dollar threatening to knock the wind out of commodity prices, strategists say Brazil's export-centred resource companies will also face some pain from the rating upgrade, since it will drive up Brazil's currency, the real. It closed Friday at a record 60.75 cents (U.S.), rising despite strength in the U.S. dollar.

The consumer staples sector also stands to take a hit, as it is dominated by food exporters.

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Nevertheless, Mr. Dennis said, those potential underperforming sectors "will only lose out relatively." Indeed, experts predict that the entire Brazilian market is in line for an upward revaluation as a result of the S&P credit upgrade.

Up until now, Brazil's below-investment-grade rating has kept its equity valuations trading at a discount to overall emerging markets - where other heavyweights China, Russia and India had already achieved investment-grade ratings. Merrill Lynch's Brazilian-based Latin American strategist, Pedro Martins, noted that this risk discount has shrunk markedly in the past two years as investors have been positioning themselves for the move to an investment-grade rating, but a small discount of about 2 per cent still remains.

However, he noted that declining Brazilian interest rates should also serve to expand valuations for Brazilian stocks.

The forward 12-month price-to-earnings multiple for the Bovespa stands at a modest 12 times, well below the 16-times forward P/Es of markets in other investment-grade countries in Latin America.

In the long term, the investment-grade rating means that a whole new class of deep-pocketed investor will now be putting money into the Brazilian market. Many major international institutional investors, including managers of big pension funds, are prohibited from investing in non-investment-grade countries due to the elevated risk. That barrier is gone now.

"It really opens the doors," said lawyer Marcio Mello Silva Baptiste of TozziniFreire, a top Brazilian law firm that represents major foreign institutional investors in the country. "Everybody's very excited right now. They think there's going to be a flood of money coming into the market."

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One of the key risks looming over the Brazilian market, though, is the slowing global economy, something that typically hits heavily cyclical markets more heavily than other more balanced markets.

"It's a very top-heavy market," Citigroup's Mr. Dennis said.

But he noted that despite the resource-heavy focus of its stock market, exports make up less than 15 per cent of Brazil's gross domestic product.

"If there's any country that can decouple from the global economy, this is one of them," he said, although he added that if commodity prices were to go into a deep slide, "it's going to recouple pretty fast."

By the numbers

Total market capitalization:

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$1.46-trillion (U.S.)

12-month market-cap increase:

76 per cent

Share of global equity market:

1.7 per cent

Trailing P/E: 16.0

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Forward P/E: 11.5

Dividend yield: 2.8 per cent

Returns

Year-to-date: up 6.2 per cent

12 months: 38.6 per cent

5 years: 440 per cent

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Biggest stocks

(with industry

and index weightings)

Companhia Vale do Rio Doce (Vale) (mining) - 15.4 per cent*

Petroleo Brasileiro SA (Petrobras) (energy) - 14.6 per cent*

Unisas Siderurgica de Minas Gerais SA (Usiminas) (steel) - 4.6 per cent

Banco Bradesco SA (banking) - 3.8 per cent

Companhia Siderurgica Nacional SA (CSN) (steel) - 3.3 per cent

(*Combined common and preferred stock, both of which are components of the Bovespa index.)

GDP growth

2007: 5.4 per cent

2008 (forecast): 4.5 per cent

2009 (forecast): 4.0 per cent

Bloomberg

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