By Birgit Jennen

The financial market meltdown a year ago brought Brazil's three-year economic spurt to an abrupt halt, silencing those who had previously held that the country would be able to weather any global financial storm because of its strong domestic economy and stable banking system, reformed after the Latin American debt crisis of the 1980s.

As raw-material prices plummeted and investor risk-appetite dried up, hopes were quenched that Brazil's economy might be immune to the woes of the global markets. The economy contracted 3.6% in the fourth quarter of 2008 and a further 1% quarter-on-quarter in the first three months of 2009.

Just one year on, however, most economists believe Latin America's biggest economy is showing signs of being among the first to rebound from the downturn. Thanks to a speedy turnaround in domestic demand, Brazil is seen as well on the path to recovery, with the economy expanding a better-than-expected 1.9% in the second quarter.

"Brazil is among the few winners of the global financial crisis," says Zeina Latif, an economist at ING Bank in Sao Paulo. This is evidenced, she says, by the fact that over the last 12 months Brazil has seen foreign direct investment rise to $39 billion from $31 billion from August 2007 to July 2008.

Potential risks from the world economy remain, however, so many experts recommend that investors focus on Brazil's more domestic-oriented names for the time being.

The country's communication sector is top of the list for Marco Gazel, economist and partner at asset manager M2 Investimentos in Sao Paulo. That industry is dependent only on the national economy and has strong growth potential once Brazil returns to past performance levels, he explains.

"Brazil's communication sector is a relatively secure investment," Gazel says. His preferred stock is

Tele Norte Leste Participacoes

( TNE), Brazil's largest fixed-line telephone company, which he expects to rise by 30% over the next six months and 50% over the next 12 months.

Another sector to look out for is Brazilian banking, he says. Brazilian banks are in a better position than many others globally, as they are strongly regulated and have been more conservative in their investment practices than, say, their Eastern European counterparts. According to Gazel, Brazilian banks are set to outperform in the future.

"Homebuilders have so far been the frontrunners in Brazil's asset rally. Banks will be the next," he says.

Banking group

Itau Unibanco

(ITUB) - Get Report

is Gazel's top stock in the sector, because of the synergic effects of the merger with Unibanco that are due to be realized over the next six to nine months. He sees upside potential of 25% to 30% in the stock in the coming 12 months.

"Most economic indicators have turned around and are signaling recovery," Latif says. "Brazil is doing really well. There has been a significant increase in manufacturing confidence and household consumption is also going well."

Manufacturing confidence, as measured by the country's Industry Confidence Index, reached 105.7 in August, close to its August 2008 pre-crisis level of 119.2. Household consumption also returned to pre-meltdown levels, with seasonally adjusted retail sales in June this year rising 5.6% year over year.

The bounce back comes after the government of President Luiz Inacio Lula da Silva last year introduced fiscal incentives, such as tax breaks on new vehicles, to help keep the economy ticking over. Brazil's central bank, meanwhile, has slashed its benchmark Selic interest rate five times this year, from a high of 13.75% in January 2009 to a record low of 8.75%.

Economists from Banco Bradesco said in a recent note to clients that they believe the central bank will keep the benchmark rate on hold throughout the next year. The most recent minutes of the central bank's monetary policy committee show the central bank sees no meaningful inflation pressure in the foreseeable future. Annual inflation was 4.36% in August, below the bank's inflation target of 4.5% for this year and next. Similarly, the government will only gradually fade out its temporary tax break on car sales, keeping the incentive in place until at least December.

"There are no clouds hanging over the consumer market," says ING Bank's Latif. "The counter-cyclical monetary and fiscal policies are working."

She expects growth domestic product growth this year to hover around 0.5%, with growth next year leaping to 4.1%. Even a weakening in China's appetite for raw materials is unlikely to pose a major threat to the country's economic outlook, she says. Domestic consumption, the backbone of the country's economy, accounts for 61% of GDP, while exports only make up 14%, with China only accounting for 10% of that, or 1.4% of the country's overall GDP.

While Brazil's growth may have been revived, risks remain. Just a year after the collapse of

Lehman Brothers

, investors see the biggest risk to the country's economy as the possibility of a second round of recession in 2010 in the U.S.

"We are dependent on a U.S. recovery," Gazel says. Any new shock to the world economy would increase risk aversion, he says, adding that he believes this to be the Achilles' heel of Brazil's recovery.

"Investment activity is still very low," Latif agrees. "Private bank credit lines to business are at very depressed levels."

Though Brazil's economy would still grow if there were a double-dip U.S. recovery, that growth would be noticeably slower, economists say. If there was a "W-shaped" recovery in the U.S., Latif says she would expect Brazil's economy to expand by 3.5% next year, while a fast "V-shaped" recovery could push growth as high as of 5.5%.