How does inflation affect investments? A complete guide from economic phenomena to asset allocation

The Truth About Rising Prices: What Is Inflation?

In recent years, global prices have continued to rise, and central banks around the world are adjusting policies intensively. Simply put, inflation is a period during which the prices of goods keep increasing, and the purchasing power of money declines—meaning money is depreciating.

The most commonly used indicator to measure this phenomenon is the Consumer Price Index (CPI), which tracks the price changes of a basket of everyday goods and reflects the overall price level.

Where Does Inflation Come From? Four Main Drivers

The fundamental cause of inflation is the excess of money supply in the economy over its actual capacity—too much money chasing too few goods. Specifically, there are several main driving factors:

Demand-Pull Inflation

When societal demand for goods increases, rising consumption drives production growth and price increases. As companies see higher profits, they invest and spend more, further stimulating overall demand, creating a virtuous cycle. Although this type of inflation pushes prices up, it also promotes economic growth (GDP), so governments usually try to encourage this demand growth.

Cost-Push Inflation

When the costs of raw materials, energy, and other inputs rise sharply, producers are forced to raise their prices. A typical example is the deterioration of the Russia-Ukraine situation in 2022, which disrupted European energy supplies, causing oil and gas prices to surge tenfold, and the Eurozone CPI growth rate exceeding 10%, setting a record. This type of inflation reduces social output and leads to a decline in GDP—something governments are keen to avoid.

Excessive Money Supply

Unrestrained increases in the money supply by governments directly trigger inflation. Historically, the most severe hyperinflations almost always stem from this. Taiwan, in the mid-20th century, experienced massive post-war deficits, with the central bank issuing large amounts of currency, eventually leading to soaring prices and currency collapse.

Self-Reinforcing Inflation Expectations

Once people expect prices to continue rising in the future, their willingness to spend increases; workers demand higher wages, and businesses raise prices further—creating a self-perpetuating cycle. Once formed, these expectations are very hard to break, so central banks worldwide strive to control inflation expectations and declare their commitment to keeping prices low.

How Do Rate Hikes Fight Inflation?

When inflation spirals out of control, central banks often raise interest rates. Higher rates increase borrowing costs—for example, if a loan interest rate rises from 1% to 5%, borrowing 1 million yuan costs annual interest from 10,000 to 50,000. As a result, companies and individuals are less inclined to borrow and prefer to deposit money in banks.

Market liquidity decreases, demand for goods naturally shrinks, and merchants can only lower prices to stimulate sales. This cycle helps curb price increases.

However, rate hikes also have costs: reduced demand can lead to layoffs, rising unemployment, slowing economic growth, and in severe cases, recession. Therefore, central banks must carefully weigh their actions—balancing price control with economic growth protection.

Is Inflation Always a Bad Thing?

Many people fear inflation, but moderate inflation can actually benefit the economy.

Positive Effects of Moderate Inflation

When people expect future prices to be higher, they are motivated to buy now, increasing consumption; businesses see opportunities and increase investment and output, ultimately driving overall economic growth. For example, in China, when the inflation rate (CPI) rose from near 0% to 5% in the early 2000s, GDP growth also jumped from 8% to over 10%.

The Dangers of Deflation

Conversely, during periods of negative inflation (deflation), markets can stagnate. After Japan’s economic bubble burst in the 1990s, the country fell into deflation—prices hardly moved, people preferred to save rather than spend, and GDP continued negative growth, leading to the so-called “Lost Thirty Years.”

Therefore, major central banks worldwide set inflation targets within a safe range: most in the US, Europe, UK, Japan, Canada, and Australia target around 2%-3%, while other countries often aim for 2%-5%.

Debtors Benefit from Inflation

Inflation causes cash to depreciate, but it benefits borrowers. For example, a loan of 1 million yuan taken 20 years ago to buy a house, with a 3% inflation rate, would be worth about 550,000 yuan in real terms after 20 years—effectively halving the debt. Thus, during high inflation periods, those who borrow to buy assets like real estate or stocks tend to profit the most.

The Dual Impact of Inflation on the Stock Market

Low Inflation Is Bullish, High Inflation Is Bearish

In a low inflation environment, market funds tend to flow into stocks, pushing prices higher. But during high inflation, central banks tend to tighten policies, often putting downward pressure on stock prices.

A clear example is the US in 2022: inflation continued to rise, with the June CPI increasing by 9.1% year-over-year, a 40-year high. The Federal Reserve began aggressive rate hikes from March, raising rates a total of 7 times, with a cumulative increase of 425 bps, bringing the rate from 0.25% to 4.5%.

High interest rates weaken corporate financing ability and lower stock valuations. The US stock market experienced its worst performance in 14 years— the S&P 500 fell 19%, and the tech-heavy NASDAQ plunged 33%.

Opportunities in Energy Stocks

However, high inflation periods are not entirely bleak. Historical data shows that energy sector stocks often perform strongly against the trend. In 2022, the US energy sector surged over 60%, with Occidental Petroleum up 111% and ExxonMobil up 74%, far outperforming the broader market.

Building a Resilient Investment Portfolio During Inflation

The key strategy to combat inflation is diversified asset allocation. Relying on a single asset class makes investments vulnerable, but a well-balanced mix can hedge against risks.

Assets That Perform Better During Inflation

In real estate, during inflation, ample liquidity often flows into property, pushing up prices. Gold and other precious metals tend to perform inversely to real interest rates (real interest rate = nominal interest rate – inflation rate); the higher the inflation, the better gold performs. Stocks, despite short-term volatility, generally yield returns exceeding inflation over the long term. Strong foreign currencies like the US dollar tend to perform well when central banks raise interest rates.

A simple allocation approach is dividing assets into three parts: 33% stocks to capture growth, 33% gold to preserve value, and 33% US dollars to hedge inflation. This diversification strategy leverages stock market potential, gold stability, and US dollar appreciation expectations, balancing risk.

A New Way to Trade Multiple Assets in One Platform

To conveniently allocate across stocks, gold, forex, and other assets, traditional methods require multiple accounts, which can be cumbersome. Contracts for Difference (CFDs) offer a simpler alternative—trading stocks, gold, forex, cryptocurrencies, and more on a single platform, with lower costs and leverage up to 200x.

Investors can assess their risk tolerance and adjust asset allocations dynamically based on inflation expectations and market conditions, seizing investment opportunities during inflationary periods.

Conclusion

Inflation is fundamentally a continuous rise in prices. Moderate inflation promotes economic growth, while excessive inflation causes harm, prompting central banks to raise interest rates and take other measures to control it. For investors, the focus should not be on fearing inflation but on understanding its mechanisms, properly allocating assets like stocks, gold, and US dollars, and ensuring their assets outperform inflation to maintain real wealth value.