Latin American stock markets, ever swayed by the winds of the U.S. stock market and economy, and battered by recent

Nasdaq Composite Index

pain, may receive a fresh round of blows from rising U.S. rates.

Hot U.S. economic data released in the past two weeks sank Wall Street hopes that the end of the

Federal Reserve's

rate-tightening cycle was near. April's unemployment figure was the real clincher. Coming in at a 30-year low, it cemented the perception that the

Federal Open Market Committee will raise interest rates by 50 rather than 25 basis points at its May 16 meeting. A


poll done on the heels of the

employment report showed that economists at 26 of 29 primary dealers expect a half-point hike.

But even more importantly, few economists still think the Fed will take a hands-off approach to the second half of this election year, with many expecting rates to rise as much as 150 basis points between now and January. In 1994, a similar pattern of U.S. rate hikes contributed to the unraveling of Mexico's economy. The shock eventually led to a devaluation of the peso and the so-called Tequila Crisis. By the time it was over, Mexico's benchmark stock index, the


, had been halved. Other Latin American economies were also damaged by the U.S. rate hikes.

Latin American economies are much stronger this time around and are unlikely to take the same kind of beating. But an extended rate-hike program in the U.S. could weaken currencies, push up interest rates and raise corporate debt spreads in the region, undercutting strong equity fundamentals and inducing a selloff.

Argentina would be the hardest hit by more aggressive U.S. interest-rate plans, according to

Salomon Smith Barney

. With its currency pegged to the dollar, it would be locked into raising its own interest rates at home. And if higher U.S. interest rates scare banks away from lending to countries with fat external deficit and debt repayment burdens, Argentine companies could have a pretty tough time getting financing for projects.

For Mexico, the real threat is that higher U.S. rates would weaken the peso more than expected, bringing on local rate increases. Brazil, on the other hand, could be forced to slow down interest-rate cuts. Chile's floating currency makes it pretty much immune to external interest-rate moves. But it could be hurt by a "hard" vs. "soft" landing in the U.S., which would slow global growth and put a dent in commodity prices, on which many Chilean companies depend.

Latin markets are already 18.5% off of their March highs, having followed the Nasdaq on its bloodied warpath into the red. And expectations of a 50-basis point rate hike have already been priced into both U.S. and Latin markets. So the real threat is for the longer term.

"We think there is going to be more pressure down the road. There is a possibility right after the Fed raises rates that the numbers will improve at that time, but later on we expect a renewed selloff," says Geoffrey Dennis, Latin American strategist at Salomon Smith Barney.

Where to Put Your Pesos

Most strategists counsel caution on Latin American stocks in the mid-term, particularly on domestic growth and interest-sensitive stocks. But cyclical stocks could make for some good defensive plays, says Dennis.

"At the margin, our new U.S. interest-rate view increases the attractiveness of deep-discount global cyclical stocks over domestic growth and interest-sensitive stocks," wrote Dennis in a recent report. "Cyclicals will be more defensive in the event that U.S. interest-rate speculation and action hits the equity markets more or earlier than we forecast." Salomon's economists raised their U.S. rate forecast to 7.5% from 6.75% Friday.

Dennis doesn't recommend reducing weightings in growth stocks at today's oversold levels, but he does recommend selling into strength sooner than later. "I still like domestic growth stocks," he says. "They have been badly hit by the recent selloff, which is not warranted due to high growth in the region."

"But there's some logic in investors being pretty defensive," he continues. "Some of the cyclicals, which have not done very well on the upside, like paper/pulp -- they didn't rally in March like the growth stocks, so they haven't come down much either." That limited downside may help investors weather the rate-hike storm.

In cyclicals, Dennis recommends pulp and paper company


(ARA) - Get Report

and Brazilian steel company

Companhia Siderurgica Nacional

(SID) - Get Report

. (Salomon Smith Barney has done no equity underwriting for these companies. Its parent,


, has extensive banking relationships in Latin America, however.)

J.P. Morgan

, meanwhile, raised a red flag on Latin stocks back in mid-February, says Carlos Asilis, the company's Latin American Equities Strategist. Asilis suggests investors wait for lower entry points, but where these will appear depends entirely upon whether the Fed is able to pilot the economy into a smooth landing or is forced to haul it down abruptly through a bit of a recession, he says.

Asilis also recommends cyclicals, and cautions strongly against buying into low liquidity stocks, like the cellular phone sector in Brazil, which he has recommended avoiding for a month.

"Counter to the U.S., where liquidity is very deep for many sectors. In emerging markets liquidity is always an issue. If you talk about leaving a growth sector like telecom you may lose liquidity. And you don't want to be illiquid during a market downturn," he emphasized.

Cyclicals Asilis finds attractive (none of which J.P. Morgan has done any recent underwriting for) Aracruz and Companhia Siderurgica Nacional, as well as Mexican conglomerates

Grupo Alfa


Grupo Carso

and retailer

Wal-Mart De Mexico


. Asilis also recommends Brazilian retailer

Companhia Brasileira

(CBD) - Get Report