As the U.S. economy flirts with recession and the Federal Reserve's rate-cutting cycle winds down, the hottest stock market for exchange-traded funds faces its stiffest headwinds since late 2002.

That's when Latin America started soaring. A combination of massive price hikes in energy and commodities along with stricter fiscal controls by leading countries has transformed the region.

But for all its advances, Latin America still remains in the shadows of its bigger neighbor to the north. With debate raging about whether the U.S. is yet to reach recessionary levels, the Federal Reserve's move Wednesday to cut short-term interest rates by a quarter-point to 2% is adding fuel to the fire.

Normally, lower rates in the states would bolster prospects for foreign investment. Such moves tend to eat away at the U.S. dollar's value on world markets, which is good news for currencies like the real and peso.

This time, however, Fed policy makers say they're ready to turn their attention to fighting inflation. While their statement didn't go as far as some had hoped in spelling an end to rate cuts, the Fed did emphasize slowing commodities prices and other key inflationary measures as significant events to monitor.

"If the Fed's rate-cutting cycle is over for awhile, the dollar should get a short-term boost," said Joe Clark, managing partner at Financial Enhancement Group LLC. "At the same time, commodities and energy prices likely face stiffer headwinds. As a result, we're expecting Latin American stock ETFs to sell-off in the near-term."

Michael Pento, senior market strategist at Delta Global Advisors in Huntington Beach, Calif., acknowledges strong sentiment in some circles that Latin American stocks will be hurt by recent developments. But he remains optimistic about international stocks in general.

Pento says that the Fed action has already been priced into the market. Indeed, in recent weeks commodities and energy traders have been taking their lumps.

"Consumers and the economy as a whole are both even more leveraged now than when rate cuts began last year," he said. "So it's hard to believe the Fed's in any better position now to start raising rates back to the 5.25% range, which is where we'd probably need to get to see any real strengthening in the dollar."

If any sell-off in Latin American stocks takes place going forward, Pento believes it'll be extremely short-lived. "I'm telling my clients that the fundamentals remain largely in-place for investing in foreign stock markets," he said.

Sole Holdout

But talk of a bubble in Latin America is gaining steam. In the past five years, the average Latin American stock mutual fund has returned an average annualized 44%-plus, easily outdistancing 36 other fund categories tracked by Morningstar Inc. The next closest is Asia ex-Japan at more than 31% per year during the same period.

This year, almost every major region is suffering from the weight of a worldwide credit crunch and slower economic growth in the U.S. The lone exception for stock fund investors has been Latin America, where the average mutual fund in that group has gained 7.6% so far. Among diversified categories, only bear market funds taking inverse positions are above water.

"In the past 15 weeks, about the only things in stocks that have worked to any extent for long investors have been Latin America's materials and energy-rich markets," said Clark, a demographics specialist who uses both technical and fundamental analysis in his independent research.

"For the short- to intermediate-term, though, we're bracing for a real sea change in sentiment by investors regarding the whole region," he added.

The advisor isn't selling his clients' positions of iShares S&P Latin America 40 Index (NYSE: ILF), which is up more than 11% in 2008. "We see long-term strength in the region," Clark said. "To us, a downturn now provides us with an opportunity to buy more shares at much more attractive pricing. This is a part of the world we see as worthy of full marriage rather than a short-term fling."

But analysts warn that volatility could increase markedly in coming quarters. The International Monetary Fund has issued a report that finds a slowing U.S. economy is likely to prove a drag on many areas in Latin America. It's also cautioning of the likelihood for a slowing in commodities and raw materials prices, pointing to a possible decline in the next year.

The combination has led the IMF to predict that Latin America's domestic product growth rate will slow by 2% to 3.9% by the end of 2009.

Since those findings were released about two weeks ago, economic leaders across the region have refuted those forecasts. And at least one noted economist, Moody's Alfredo Coutino, has also taken exception to the IMF analysis.

"While certainly no country in the region is immune from what's going on in the U.S., the IMF's conclusions are drawn from historic factors," he said.  

The last time a major global downturn hit Latin America was seven years ago. Since then, countries in the region have bolstered their reserves and built large fiscal surpluses, Coutino says.

Much of that has been due to profits in commodities and energy markets. But another major contributor that shouldn't be discounted, Coutino argues, is that Latin American policy makers have been very attentive in controlling debt and managing inflation.

In fact, the region now has become a net exporter, selling more of its goods and services to other parts of the world than it needs to import from outside markets, he points out. "While U.S. economic activity enters a recession, Latin America is moving in the opposite direction," Coutino said. "What we've really seen since the last financial crisis in the region is a decoupling of its economies from the U.S."

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