It's winter in South America right now but Latin American funds are anything but cool.

While U.S. stocks have spent the summer on a volatile trip to nowhere -- the

S&P 500

is up a forgettable 1.27% over the past three months -- Latin American stocks and funds have taken off.

The

iShares S&P Latin America 40 index

(ILF) - Get Report

exchange-trade fund, which includes the largest Mexican and South American stocks, is up 18.54% for the last three months and 26.43% over the last 100 days.

The average Latin American stock fund has gained 17.52% over the last three months. By comparison, the next best-performing international regional fund category, diversified Pacific funds, returned just 3.87% during that time, according to fund-tracking firm Morningstar.

"When you discuss Latin American equities, you are basically talking about Brazil and Mexico," says Zack Henry, Latin American economist for auto manufacturer

Toyota

. "And this summer rally is primarily being driven by long-awaited domestic growth in Brazil and increased confidence in

President Luiz Inacio Lula da Silva Lula's economic policies."

Basically Brazil

Brazil's impact on any Latin American equity index is impossible to miss. Companies from the country comprise 49.1% of the seven-country

MCSI Latin America Index

, with Mexico a distant second at 32.8%. The remaining five countries -- Chile, Colombia, Argentina, Venezuela and Peru -- combine for the remaining 18.1% of the index (see chart below).

So despite the fact that Mexican stocks in the

iShares MSCI Mexico Index ETF

(EWW) - Get Report

are up 3.8% over the past three months (triple the S&P 500), the major driver of Latin American fund performance undoubtedly has been Brazilian stocks. The

iShares MSCI Brazil Index ETF

(EWZ) - Get Report

has risen more than 34% since May.

"Generally, there is a return to growth by Brazil," says Brad Durham, a managing director at Emerging Portfolio Fund Research. "The inflation data has been positive and the government is creating the right environment for economic growth." Durham says recent economic data indicate 4% growth in Brazil after a flat 2003.

Latin American Leaders
MCSI EMF Latin America Index, Aug. 23

Source: MCSI

In addition, higher oil prices are unlikely to hamper growth in Brazil as much as in other countries, such as the U.S., which are more reliant on foreign oil. Brazil is the third-largest oil producer in Latin America behind Mexico and Venezuela and possesses the second largest oil reserves in the region. Due to intensified oil exploration and development, particularly in the offshore Campos basin north of Rio de Janeiro, and falling domestic consumption, Brazilian oil imports actually have dropped substantially since the 1970s.

Brazil's state-owned oil company

PetroBras

(PBR) - Get Report

, of course, has benefited from the rise in oil prices; its shares are up 25% over the past three months. PetroBras' impact on the performance of Latin funds is also undeniable. The company has the third-largest allocation in the S&P Latin America 40 Index at 10.15%, behind Mexico's

America Movil's

(AMX) - Get Report

12.33% and

Telefonos de Mexico's

(TMX)

10.44%.

Analysts may give Lula a lot of credit for steadying Brazil's economy, but the unconventional president might want to send a note of thanks northward to

Fed

Chairman Alan Greenspan for keeping U.S. rate hike fears in check.

Fears of a steep hike in interest rates swept through U.S. markets in April, driving the yield on the 10-year Treasury from below 4% to more than 4.75% by early May. The unrest in U.S. credit markets caused a selloff in emerging markets indices, as hedge fund and other institutional investors nervously unwound their carry trades, which meant selling off emerging market currencies, stocks and bonds. The S&P Latin America 40 index, for instance, sank more than 20% during the period.

(The carry trade is when investors -- especially hedge funds -- borrow money at cheap short-term rates in order to find higher returns in longer-term vehicles elsewhere. A significant portion of that borrowed money flowed into higher-yielding emerging market bonds.)

Since the spring selloff, however, investors worldwide seem to have bought into Greenspan's strategy of a "measured" pace for rate hikes. And Latin American stocks have sprinted forward as the yield on the 10-year Treasury has fallen to 4.28% from its May high.

Looking Ahead

Todd Henry, emerging markets specialist at T. Rowe Price, says interest rates will remain a concern for Latin American economies, not just because of the carry trade, but for more traditional reasons.

"Latin American companies and countries traditionally have a lot of debt and servicing that debt will become much more difficult if interest rates move sharply higher," says T. Rowe's Henry.

Henry also cites a potential economic slowdown in China as another concern. Commodity exports to China have been a major driver in Brazil's economic resurgence.

If so, any slowdown in Brazil may end up being a positive for Mexican shares, which still comprise close to a third of most Latin American funds' assets.

"Mexico is more of a defensive market," says Henry. "It's like a higher beta proxy on the U.S. recovery." That role has not been lost on investors.

The

iShares MSCI Mexico Index ETF

(EWW) - Get Report

is up 12.35% year to date compared with a loss of approximately 1% for the

iShares MSCI Brazil Index ETF

(EWZ) - Get Report

.

So, American investors seeking returns south of the border may be staying closer to home in the months ahead.