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The Great Inflation Is Coming

By Sean Hannon, CFA, CFP, of EPIC Advisors from Covestor.com.

The "Great Inflation" is coming. While that statement might seem odd in an environment where economic activity is collapsing and deflation threats remain, we need look no further than last week's statement from the Federal Reserve that it is intent on creating inflation and will do anything necessary to make it occur.

The Fed indicated it will keep the size of its balance sheet at high levels, will continue purchasing large amounts of agency debt and mortgage-backed securities (MBS), and is prepared to purchase long-term Treasury securities. This translates to a Fed that will target various points on the interest rate curve, keep rates artificially low for a sustained period, and not stop until deflation ends and inflation returns. Right now, the Fed is all-in and will keep placing bets until it achieves its goals.

That excess money at artificially low rates will lead to inflation is not a question of if, but when. The transition could occur as late as 2010, but it will occur, and investors should ask themselves how to prepare for the change.

Modern portfolio theory teaches us that the risk of individual assets does not matter as much as the risks between assets in a diversified portfolio.

With inflation coming, we should look for assets that will benefit from higher interest rates while offering low correlations with our existing portfolio.

During inflationary times, precious metals and other commodities offer the best returns. With the advent of various ETFs, individual investors can easily craft commodity-based strategies. However, I will not be going in that direction. Pure commodity exposure offers limited income and wild volatility. Instead, I recommend diversified investments with strong income potential that offer commodity exposure and risk reduction-index funds of commodity-producing nations.

Believing that commodities will outperform in an inflationary environment, we should expect the stock exchanges of commodity-producing countries to outperform as well. Three of the bigger commodity producers are Australia, Brazil, and Canada. By buying ETFs that track their markets, we will diversify our portfolio, earn an average dividend yield of 5.5%, and be positioned to benefit from an eventual return of inflation. Such a combination offers an excellent opportunity to effectively deploy capital in a challenging market.

For these investments, I will be using the following ETFs: iShares MSCI Australia Index (EWA), iShares MSCI Brazil Index (EWZ), and iShares MSCI Canada Index (EWC).

At the time of publication, Sean Hannon had no position in funds mentioned. Positions may change so click here to view their current portfolio. Sean Hannon has their investment record verified by Covestor.com. Visit Covestor.com to track the real investments of thousands of proven self-investors live for free.

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