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Updated from 4:38 p.m. EDT



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legal liability. Slowing corporate earnings growth.


tightening. The housing bubble and consumer indebtedness have all been cited as potential bull killers.

But if it's usually the thing people


worried about that hurts Wall Street, consider Brazil. On Friday, the nation's stocks, currency, and government bonds took a beating -- along with emerging-market debt in general -- after mounting allegations of corruption hit Brazilian finance minister Antonio Palocci, the closest adviser to President Luiz Inacio Lula da Silva.

By Monday, however, there weren't any signs that risk aversion to investments in Brazil or the region was spreading further. Brazil's currency, the real, gained 2% against the dollar, after falling 2.8% Friday. After slumping 2.75% on Friday, Brazil's Bovespa Index closed up 2.3% Monday; and while major U.S. stock proxies posted modest gains, Brazilian ADRs such as

Petroleo Brasileiro

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( TNE) and

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( TCN) were each up more than 3.5% while

The Brazil Fund


, a closed-end fund that invests primarily in Brazilian equity securities, climbed 5%.

The rebound came as the Palocci firmly denied any links with the graft scandal currently rocking the country's political establishment. But the country's strong economic and financial fundamentals also are buffering any short-term impact on markets.

"There is uncertainty, but the economy and the fiscal situation in Brazil remain in very good shape," says David Watt, senior economist at BMO Nesbitt Burns. "They're now very well insulated from global shocks, so you'll find global risk takers are still willing to put money in there."

Since June, allegations that Lula's Workers' Party used campaign funds to buy support and influence in Congress have mounted and are now reaching the highest levels of government.

Still, Brazilian markets have mainly continued to rally over the past two months, remaining buoyed by the so-called carry trade, whereby investors borrow money at cheap U.S. rates to invest it in more risky, higher-yielding investments. Even after 10 Federal Reserve rate hikes, the 3.50% fed funds rate pales vs. the short-term interest rate in Brazil, which is 19.75%.

Thanks to that attractive spread and successful economic reforms, which outweigh the risks, Brazil has been one of the main stars of emerging markets. The popularity of investments in Brazil actually has kept investment risk premiums at low levels.

Even since June, the Bovespa has risen another 3.0% in dollar terms. The benchmark MSCI Brazil index is up 8.3%. Brazil's sovereign debt has also improved, with the spread between yields of its government bonds and those of U.S. Treasuries falling 10 basis points. The real is down 1.7% against the dollar since June, but it's up 14% so far this year.

Yet, the market jitters seen on Friday signal that the allegations hitting Palocci are particularly troubling for investors. As Lula's closest ally and adviser, Palocci has been key in shaping Brazil's market-friendly policies over the past two years. More importantly, a recent poll in Brazil showed rising support, at 30%, for an eventual impeachment of Lula himself.

That led Citibank global equity strategist Geoffrey Dennis to downgrade the overall Brazil stock market to neutral from outperform. While the likelihood of a Lula impeachment is still remote, short-term uncertainty is likely to last at least through next month while opposition parties choose whether or not to launch impeachment proceedings.

In Dennis' view, the resilience of Brazilian assets throughout the mounting scandal cannot be sustained going forward. Using his models, he says an impeachment would lead the Bovespa to drop 40%-45% in dollar terms. The real would drop to 2.95 against the dollar compared to 2.38 currently, and debt spreads would widen 200 basis points.

"Therefore, the risk-reward calculation for this market -- at the top end of its trading range -- is becoming unattractive," Dennis wrote.

While risk premiums may be more elevated while the political scandal plays out, the longer-term outlook for Brazil's economy and markets remains bright. Notably, the strategist remains bullish on Brazil over the long term and keeps an overweight rating on Brazilian cyclical stocks.

Should Lula avoid impeachment, the most likely scenario so far, the Bovespa should rise by more than 10% by year-end, Dennis says.

Even if the opposition takes over, analysts believe that Brazil's open-market and business-friendly policies would remain in place. Outside of short-term political risks, the outlook for Brazil remains bright.

The country has become the No. 1 food supplier in the world, and as such, it has linked its fate to the insatiable appetite of the Chinese economy. Its trade surplus is expected to reach 5% of GDP this year, and its current account surplus is close to $40 billion.

There is also little risk that the situation in Brazil could deteriorate into something more serious such as the Russian debt crisis in 1997, or any of the more recent currency crises in Argentina, according to Paulo Vieira da Cunha, chief Latin American economist with HSBC Securities in New York.

Hedge funds have been active investors in Brazil, as in most emerging markets, and they could all bail out at once should a collapse of the real appear to be in the cards. Short-term interest rates are expected to come down over the next few months.

But the currency is not overvalued given the strong economic fundamentals, such as the trade and current account surpluses, says Cunha. Besides, while the government has been staying out of foreign exchange altogether, Brazilian exporters seeking currency hedges have actually been purchasing dollars and selling the real.

While it has benefited from the carry-trade, money pouring into the country is "the tail of that process and it's not wagging the dog," Cunha says. Should it all move out at once, $40 billion would not be enough to seriously rock the country nor the world's financial system, he adds.

A much bigger risk for Brazil as for all emerging markets would be if long-term U.S. rates were to rise sharply, say if the housing bubble bursts, which could precipitate a collapse of the Brazilian real, Cunha says. But if that happens, there wouldn't be many places for global investors to hide.

Back on the Home Front

A merger-Monday frenzy had first inspired market participants, with the

Dow Jones Industrial Average

rising by up to 80 points in morning trade. But the blue-chip index closed up a modest 10.66 points, or 0.1%, at 10,569.89.


S&P 500 index

gained 2.02 points, or 0.17%, to 1221.73. The

Nasdaq Composite

added 5.85 points, or 0.27%, to 2141.41.

"We've actually seen this pattern over the past couple of weeks. The market starts out strong in the morning, and then the air comes out of the sails, and then we challenge the opening levels, and there's further deterioration throughout the week," says Chris Johnson, market strategist with Schaeffer Investment Research.

So far, support has held for the S&P 500 at 1220, its 50-day moving average. "If we break through that key support level, we can expect a much larger selling bias going forward," Johnson says.

Volumes were very light, with only 1.2 billion shares trading on the


and 1.4 billion on the Nasdaq. Breadth was positive, with gainers outpacing declining issues 10 to 6 on the NYSE and 17 to 13 on the Nasdaq.

Oil also continued to weigh on the market, after evidence last week that


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customers were feeling the pinch of surging gasoline prices. Crude finished up 10 cents at $65.45.

Still, higher crude oil, together with merger news in the sector, boosted energy shares and provided a floor for major stock averages.

Only a few weeks after



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failed bid for


( UCL), China's CNPC International stepped reached a deal to buy Canada's


( PKZ) for $55 a share, or about $4.2 billion.

In other merger news, German shipping company


( TUI) agreed to buy CP Ships for $2 billion.



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acquisition of


( MYG) for $21 a share was cleared after news that Ripplewood Holdings won't raise its bid for the appliance maker

There was also merger news in the health care sector, helping to offset

ongoing concerns over Merck's legal challenges. Merck fell another 0.6% Monday after losing over 8% on Friday.

OSI Pharmaceuticals

( OSIP) agreed to buy

Eyetech Pharmaceuticals

( EYET) for $935 million.

Also, shares of

Panacos Pharmaceuticals


soared 46% after the company said its experimental HIV drug met a primary endpoint in a mid-stage study.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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