How does inflation affect your assets? An in-depth analysis of investment strategies during inflation

Why Should We Pay Attention to Inflation?

In recent years, global prices have continued to rise, and Taiwan’s central bank has raised interest rates five times in a row. Many people ask: what does inflation really mean for us? In fact, understanding the mechanisms of inflation and investment strategies has become essential financial literacy for modern individuals.

The Essence of Inflation: Currency Depreciation or Economic Phenomenon?

Inflation refers to the sustained increase in the prices of goods and services over a period of time. Consequently, the purchasing power of our money decreases. In simple terms, it means money becomes less valuable.

The most commonly used indicator to measure inflation is the Consumer Price Index (CPI). When CPI continues to rise, it indicates that the cost of living is increasing.

How Does Inflation Occur?

An excess of money in circulation, combined with relatively insufficient goods to purchase, is the fundamental cause of inflation. Several factors often trigger inflation:

Demand-driven: When consumer demand increases, businesses raise production and prices. As profits grow, companies continue investing and consuming, creating a virtuous cycle. This type of inflation, while pushing up prices, also boosts GDP growth, and governments usually encourage this phenomenon.

Cost-push: Sharp increases in raw material or energy prices can also cause inflation. During the Russia-Ukraine conflict in 2022, Europe’s energy supply was disrupted, causing oil and gas prices to soar tenfold. The Eurozone’s CPI annual growth rate exceeded 10%, reaching a record high. Such inflation suppresses economic output and leads to GDP decline, which governments want to avoid.

Excessive money supply: Overprinting money by the government directly causes inflation. Many historical hyperinflations stem from this. In Taiwan during the 1950s, due to severe post-war government deficits, banks issued large amounts of currency, resulting in 8 million legal tender notes being worth only 1 US dollar.

Expectations: If people expect future prices to rise, they will buy in advance; at the same time, they demand higher wages, prompting businesses to raise prices, forming a self-fulfilling inflation cycle. Once this expectation becomes deeply ingrained, it becomes very difficult for central banks to suppress inflation thoroughly.

How Do Rate Hikes Combat Inflation?

The common tool used by central banks is raising interest rates. Higher interest rates mean increased borrowing costs. For example, if the previous loan interest rate was 1%, borrowing 1 million would cost 10,000 per year; after raising rates to 5%, the same loan would cost 50,000 per year.

High interest costs discourage borrowing, leading the public to prefer saving. Market liquidity decreases, demand for goods drops, and merchants must lower prices to attract customers. This process helps curb inflation.

But there is a clear price: reduced demand can cause companies to lay off workers, increase unemployment, slow economic growth, and even trigger recessions. Therefore, while rate hikes are effective against inflation, they can also cause serious economic downturns.

Is Moderate Inflation Truly Beneficial to the Economy?

Many people fear inflation, but moderate inflation is actually beneficial.

When people expect future prices to rise, their purchasing motivation increases. Demand grows, prompting businesses to expand investment and capacity, which drives economic development. China’s experience in the early 2000s illustrates this well: when CPI rose from 0 to 5%, GDP growth accelerated from 8% to over 10%.

A negative example is deflation. When prices stagnate or fall, people tend to save rather than spend, leading to negative economic growth. After Japan’s asset bubble burst in the 1990s, the country fell into deflation, resulting in the “Lost Thirty Years.”

Therefore, major central banks worldwide set inflation targets within a reasonable range. The US, Europe, the UK, Japan, Canada, Australia, and others aim for around 2%-3%; most countries set targets between 2%-5%.

Who Profits from Inflation?

Debtors are the beneficiaries of inflation. Although cash loses value, borrowers’ real repayment amounts shrink. For example, a loan of 1 million to buy a house taken 20 years ago, with a 3% inflation rate, is only worth about 550,000 in real terms after 20 years.

Thus, during high inflation periods, investors who use debt to purchase assets (stocks, real estate, gold, etc.) tend to profit the most.

The Dual Impact of Inflation on the Stock Market

In summary: low inflation benefits stocks, high inflation harms stocks.

In a low inflation environment, hot money flows into the stock market, pushing up prices. But during high inflation, central banks adopt tightening policies to control inflation, leading to falling stock prices.

2022 is a typical example. That year, CPI rose 9.1% year-over-year (a 40-year high in June). The Federal Reserve began aggressive rate hikes in March, raising rates seven times for a total of 425 basis points, from 0.25% to 4.5%. Rising borrowing costs suppressed corporate valuations. As a result, the S&P 500 fell 19% for the year, and the Nasdaq plunged 33%.

However, this does not mean stocks cannot be traded during high inflation. The energy sector often performs counter-cyclically. In 2022, the US energy sector returned over 60%, with Occidental Petroleum up 111% and ExxonMobil up 74%.

Building an Inflation-Resistant Asset Portfolio

In an inflationary environment, diversified asset allocation becomes crucial. The following asset classes tend to perform well:

Real Estate: During inflation, ample liquidity drives funds into the housing market, pushing up property prices.

Precious Metals (Gold, Silver): Gold’s performance is inversely related to real interest rates (nominal interest rate minus inflation rate). The higher the inflation, the stronger gold tends to perform.

Stocks: Short-term performance varies, but long-term returns generally outpace inflation.

Foreign Currencies (USD, etc.): During rate hike cycles, the US dollar appreciates, providing a hedge against inflation.

Practical allocation suggestion: Divide your funds into three equal parts—33% each in stocks, gold, and USD. This way, you can enjoy stock market growth potential, hedge value with gold, and benefit from USD appreciation, while diversifying risks across assets.

How to Quickly Allocate a Diversified Asset Portfolio?

Traditional methods require opening accounts with different brokers and futures firms, which can be cumbersome. Now, a more convenient solution is Contract for Difference (CFD) trading. CFDs cover a wide range of assets including stocks, gold, forex, and digital assets, allowing you to allocate your desired assets in one platform with high leverage, helping investors efficiently seize inflation-related investment opportunities.

Summary

Inflation is the phenomenon of rising prices. Moderate inflation promotes economic growth, but excessive inflation damages the economy. Central banks use rate hikes to curb high inflation, which is effective but costly.

In an inflationary era, smart investors allocate funds across stocks, gold, USD, and other diversified assets to hedge against currency depreciation and seize market growth opportunities. Understanding inflation mechanisms enables investors to find certain returns amid uncertainty.