How does inflation actually affect investments? An in-depth analysis of asset allocation opportunities during inflation

In recent years, the phenomenon of global inflation has been frequent, with Taiwan experiencing a significant increase in prices. The central bank has raised interest rates multiple times to cope with the pressure. However, many people lack a proper understanding of the essence of inflation and do not know how to adjust their investment strategies in such an environment. This article will analyze the causes of inflation, central bank policies, economic impacts, and specific asset allocation plans one by one.

What is the essence of inflation?

Inflation refers to the economic phenomenon where, over a certain period, the prices of goods generally and continuously rise, and accordingly, the purchasing power of money declines. Simply put, your money becomes less and less valuable.

The main indicator used to measure inflation is the Consumer Price Index (CPI). Central banks and economic sectors track changes in CPI to determine whether inflation is within a controllable range.

How does inflation occur?

The fundamental cause of inflation is: the total amount of money in circulation exceeds the supply of actual goods and services. Too much money chasing too few goods ultimately leads to rising prices. Major historical inflation events can be summarized into the following categories:

Demand-pull inflation: When consumer demand for goods increases, businesses will increase production and raise prices to gain higher profits. As profits increase, they continue to expand consumption and investment, forming a demand spiral. Although this type of inflation causes price rises, it also drives GDP growth, and governments usually welcome this moderate inflation.

Cost-push inflation: Inflation triggered by soaring production costs such as raw materials and energy. A typical example is during the Russia-Ukraine conflict in 2022, when Europe was unable to import crude oil and natural gas from Russia, leading to energy prices skyrocketing tenfold, with the Eurozone CPI annual growth rate exceeding 10%, reaching a historic high. This type of inflation suppresses social output and causes GDP to decline, which is the least desirable outcome for governments.

Excessive monetary issuance: When the government indiscriminately increases the money supply, it directly pushes up prices. Many hyperinflations in history stem from this. For example, in Taiwan in the 1950s, to resolve post-war fiscal deficits, the central bank issued大量货币, resulting in 8 million legal tender notes only being exchangeable for 1 US dollar.

Rising inflation expectations: Once the public expects future prices to continue rising, they will rush to buy goods, businesses will demand higher wages, and merchants will raise prices accordingly, ultimately falling into an inflation cycle. Once inflation expectations are formed, they are difficult to break, so the central bank must continuously send signals to suppress inflation.

Why can raising interest rates curb inflation?

When inflation is severe, the primary measure taken by the central bank is raising interest rates—increasing the benchmark interest rate to raise the overall market borrowing costs.

The logic behind raising interest rates is: when the cost of borrowing rises, enterprises and individuals are less willing to borrow and prefer to deposit money in banks. This directly reduces market liquidity and decreases demand for goods. As demand drops, merchants will lower prices to attract consumers, ultimately achieving the goal of controlling prices.

Specifically, if the loan interest rate rises from 1% to 5%, the annual interest on a 1 million loan increases from 10,000 to 50,000, and this additional expense will cause many to abandon borrowing.

However, raising interest rates has costs: when demand weakens, companies no longer need to expand production and hiring, which may lead to rising unemployment, slowing economic growth, or even recession. In 2022, the US experienced exactly this situation— to curb high inflation, the Federal Reserve raised rates 7 times by a total of 425 basis points, from 0.25% to 4.5%, resulting in the worst stock market performance in 14 years.

Moderate inflation is actually beneficial to the economy

It may seem that inflation is a bad thing, but in reality, moderate inflation is crucial for healthy economic development.

When people expect prices to rise, they tend to increase consumption, which boosts demand and encourages businesses to invest and expand production, thereby driving GDP growth. For example, in China, from the early 2000s, when inflation rose from 0 to 5%, GDP growth also surged from 8% to over 10%.

Conversely, deflation (inflation rate below 0) is the real economic killer. Japan, after its economic bubble burst, fell into deflation, with stagnant prices leading people to save rather than spend, causing negative GDP growth and ultimately entering the “Lost Decade” of 30 years.

For this reason, major central banks worldwide set their target inflation rate within a reasonable range: the US, Europe, the UK, Japan, Canada, Australia, and other developed countries aim for 2%–3%, while other countries generally target 2%–5%.

Who benefits and who suffers during inflation?

Inflation may seem to harm everyone, but in fact, beneficiaries and victims are clearly divided.

Those with debt benefit the most from inflation. Although cash depreciates, if you are a borrower, the actual amount you need to repay will be significantly reduced. For example: borrowing 1 million with a 3% inflation rate 20 years ago to buy a house, after 20 years, 1 million is only worth about 550,000, so you only need to repay half the amount. Therefore, during high inflation periods, investors who leverage debt to buy real assets like real estate and stocks benefit the most.

The dual impact of inflation on the stock market

The effect of inflation on the stock market shows a clear nonlinear relationship:

Low inflation phase: The stock market often performs well. Market funds flow into stocks, pushing up prices.

High inflation phase: Central banks are forced to tighten monetary policy, and stock markets usually decline. 2022 is a textbook example—US CPI hit 9.1% in June (a 40-year high), and the Federal Reserve aggressively raised interest rates, causing the S&P 500 to fall 19%, and the Nasdaq, heavily weighted in tech stocks, fell 33%.

However, high inflation does not mean all stocks crash. Energy stocks often rise against the trend. In 2022, the US energy sector returned over 60%, with Western Oil up 111% and ExxonMobil up 74%. This is because high oil prices directly increase energy companies’ profits.

Asset allocation strategies during inflation

In an inflationary environment, proper asset allocation is crucial. The following investment assets have shown good performance historically and have specific characteristics:

Real estate: During inflation, liquidity is abundant, and large amounts of capital flow into the real estate market, pushing up property prices. Real estate has both preservation and appreciation features.

Precious metals (gold, silver): Gold has an inverse relationship with real interest rates. The higher the inflation rate and the lower the real interest rate, the more attractive gold becomes. Historically, it is an effective hedge against inflation.

Stocks: Short-term performance varies, but over the long term, returns usually outpace inflation. Defensive sectors like energy and utilities are particularly resilient.

Foreign currencies (USD): During inflation, the Federal Reserve tends to adopt a relatively hawkish stance, leading to USD appreciation. Holding USD can hedge against domestic currency depreciation.

Building a balanced asset portfolio is key. For example, allocating funds in a 33%, 33%, 33% split among stocks, gold, and USD can allow participation in stock market growth while hedging inflation risk through precious metals and strong currencies, reducing overall volatility.

Summary

The essence of inflation is currency devaluation, but its impacts go far beyond simple price increases. Moderate inflation promotes economic growth, while high inflation threatens economic stability. Although raising interest rates can curb inflation, the cost may be triggering an economic recession.

In an inflationary environment, passively holding cash is unwise. Savvy investors should actively diversify their assets—real estate, precious metals, stocks, foreign currencies—to protect wealth purchasing power and seek growth opportunities. Especially for debtors, inflation can be an optimal window to leverage and optimize asset structures.