As the global economic picture continues to steadily improve, it’s becoming increasingly important that we take steps to hedge our portfolios against coming inflation. And inflation will indeed emerge, as more central banks step in with policy accommodations to ensure that the recovery doesn’t lose steam.

In the inaugural issue of the Inflation Survival Letter, I explained that commodities, international stocks and currency diversification are among your best tools for protecting purchasing power. While we could use individual stocks and funds to harness each of them, some single-country exchange-traded funds (ETFs) provide all three in a single wrapper.

Emerging Recovery Down Under

Australia hasn’t been left untouched by weak commodity prices and the Chinese slowdown, but it has experienced continuous economic growth for more than 20 years, while maintaining relatively low unemployment and keeping a lid on inflation.

The country’s current unemployment rate of 5.5 percent is well below the 7.2 percent peak of the early 2000s and has held in a fairly steady band between 5 percent and 6 percent for the past three years. The Australian Office of Financial Management also reports that public debt is currently just 20.7 percent of gross domestic product and annualized inflation is running at 2.7 percent, within the Reserve Bank of Australia’s comfort zone of between 2 percent and 3 percent.

Despite these relatively sound economic fundamentals, Australian equities as measured by the ASX 200 Index have returned just 10.9 percent versus an 18.5 percent gain on the S&P 500 so far this year. China accounts for nearly 30 percent of Australia’s exports, so the lagging performance can be largely attributed to falling Chinese demand for everything from Australian coal and iron ore to meat and wheat. When China’s economy surges, so does Australia’s and vice versa (see graph below).



However, indicators around the world show that the Chinese economy is bottoming out and a nascent global economic recovery could help get the Chinese economy humming again.

Most importantly, Europe appears to be emerging from its recession, with German business confidence and manufacturing activity on the rise. European manufacturing activity also crept back into growth territory in July, for the first time in a year and a half.

Even as Europe’s economy shows initial signs of recovery, China has embarked on another round of stimulus measures including tax cuts, export regulation reform and a massive railway spending program. The Chinese government is also providing liquidity assistance to the country’s banks and the People’s Bank of China has said that it is removing the longstanding floor on commercial lending rates.

With the floor removed and the ceiling raised, Chinese banks will have more room to compete on lending rates. That flexibility should spur credit growth now that most banks will be able to operate on their own terms.

Considering that Europe is China’s single largest trading partner, improvement in the region will drive demand for Chinese goods, thereby creating demand for raw materials from Australia. China’s own accommodative economic stance should further enhance that trend.

But the Australians aren’t sitting on their laurels, either.

Last week, the Reserve Bank of Australia (RBA) cut its benchmark interest to an all-time low of 2.5 percent from 2.75 percent. There’s a political link to this action, because just a few days prior Australian Prime Minister Kevin Rudd called a general election for September 7. However, the lowered rates are clearly aimed at jumpstarting growth, an imperative highlighted by the fact that the central bank lowered its 2013 growth outlook from 2.5 percent to 2.25 percent.

There has been a great deal of speculation that another rate cut might be in the offing before the end of the year, but RBA has subtly shifted its policy language on rates to indicate that it expects this most recent cut to do the trick in terms of growth.

While the change in language has damped investor enthusiasm to some degree, with a relatively tame inflation rate the RBA clearly has the scope to cut rates further if necessary. That aside, the simple fact that the central bank has taken a more accommodative stance is bullish for Australian equities based on past experience in other countries. There’s nothing the markets like more than cheap money.

Given this positive confluence of news, I’m adding iShares MSCI Australia Index Fund (NYSE: EWA) to the Survive Portfolio. Not only are resource nations such as Australia an excellent hedge against inflation, they’re a terrific play on the global return to growth.

Australian banks figure heavily in the fund’s portfolio at just over 50 percent of assets and include names such as Commonwealth Bank of Australia (ASX: CBA) and Westpac Banking Corp (ASX: WBC).

While there’s been some concern about the health of Australia’s banking industry after the country went through a housing bubble of its own, Moody’s Investors Service reports that the nation’s banks continue to report healthy capital levels and consistently solid credit metrics, on top of recently bumping up their dividend payout ratios.

According to the Moody’s analysis, the banks should be able to maintain both their dividend payouts and capital levels if the country were to experience an economic downturn similar to that suffered in 1991.

With the banks in a good state of health, they should benefit from the RBA’s recent cut in interest rates as loan demand picks up in response to cheap money and economic improvement.

The fund’s next largest allocation is to the materials sector at 19.1 percent of assets, with top names that include mining giants BHP Billiton (ASX: BHP) and Rio Tinto (ASX: RIO) and lesser-known energy names such as Woodside Petroleum (ASX: WPL).

The performance of Australia’s materials sector has been relatively flat over the trailing year, largely thanks to concerns over China. But shares have been rallying over the past month on stronger economic news, both from China and around the world, and I look for that rally to continue.

Another plus for the fund is that it doesn’t hedge its exposure to the Australian dollar. Over the past three months, that lack of hedging activity has been a headwind for the fund as the Aussie has fallen from a position of strength in mid-April, fetching about USD1.05, to weakness when it bottomed at USD0.89 earlier this month (see graph below).



But the Aussie has been staging a recovery over the past week, despite the central bank’s rate cut, largely because of an improving Chinese outlook and greater materials demand. The markets are also increasingly skeptical of another rate cut, another positive for the currency which is helping to drive a re-appreciation.

The remainder of the fund’s assets is scattered across consumer names, utilities, telecoms and health care sectors, all of which will benefit from a strengthening Australian economy.

Two other major positives for the fund are the fact that it charges a low 0.53 percent annual expense ratio and, thanks to the recent payout increases by the banks, currently yields 6.2 percent. While the fund’s dividends are subject to some foreign tax withholding, they can be claimed for a tax credit or used as an itemized deduction if you hold the fund in a taxable account.

As both an inflation hedge and a play on an improving global economic picture, new Survive Portfolio holding iShares MSCI Australia Index Fund is a buy up to 30.