Who can profit in the era of inflation? Mastering these asset allocation strategies is the only way to protect your wealth

In recent years, global prices have continued to rise, and central banks around the world have implemented interest rate hikes to combat inflation. But did you know? Moderate inflation can actually be an opportunity for certain people. This article will help you gain a deeper understanding of inflation phenomena and identify investment breakthroughs.

What exactly is inflation?

Simply put, inflation is a period during which prices continuously rise, leading to a decline in the purchasing power of money. The most commonly used indicator to measure inflation is the Consumer Price Index (CPI), which reflects changes in the cost of living for ordinary households.

Prices in Taiwan have surged over the past two years, and the central bank has raised interest rates multiple times in response. But can raising interest rates truly solve inflation? What economic principles are behind this?

Where does inflation come from? Four main causes explained

The fundamental cause of inflation is that the amount of money in circulation exceeds the size of the economy—too much money chasing too few goods. The specific factors that trigger inflation include:

Demand-pull inflation

When consumer demand increases, both the production and prices of goods rise, and corporate profits also increase. Profits lead to more investment and consumption, creating a positive feedback loop. This “demand-pull” inflation, while pushing up prices, also stimulates economic growth (GDP growth). Therefore, governments worldwide are eager to stimulate demand.

Cost-push inflation

Rising raw material prices cause “cost-push” inflation, which is the most troublesome. During the Russia-Ukraine conflict in 2022, Europe’s imports from Russia were blocked, energy prices soared tenfold, and the Eurozone’s CPI annual increase exceeded 10%, setting a record high. This type of inflation can lead to a decline in social output, with GDP contracting, which is the least desirable situation for governments.

Excessive money issuance

Unrestrained printing of money by governments directly causes runaway inflation. In Taiwan during the 1950s, to cope with post-war deficits, the central bank issued large amounts of currency, leading to 8 million legal tender notes being worth less than 1 US dollar. Most hyperinflations in history originate from this.

Rising inflation expectations

When people expect prices to continue rising, they will preemptively spend and demand higher wages, prompting businesses to raise prices accordingly, creating a vicious cycle. Once inflation expectations form, they are difficult to break. This is why central banks worldwide emphasize, “We can definitely control inflation.”

Why can raising interest rates curb inflation? But at what cost?

When the central bank raises interest rates, the cost of borrowing increases. For example, if the interest rate rises from 1% to 5%, the annual interest on a 1 million yuan loan jumps from 10,000 to 50,000. Higher interest rates discourage borrowing, encourage people to keep money in banks, reduce market liquidity, decrease demand for goods, and thus help lower prices.

However, raising interest rates also has downsides. Reduced demand from businesses can lead to layoffs, increasing unemployment, slowing economic growth, and even triggering a recession. That’s why central banks’ interest rate hikes are always a “dilemma.”

Is low inflation good, and who benefits from high inflation?

Many people fear inflation, but moderate inflation (2%-3%) is actually beneficial for the economy. When people expect prices to rise, their consumption motivation increases, boosting demand and encouraging business investment, ultimately driving economic growth. For example, in China, CPI rose from 0 to 5% in the early 2000s, and GDP growth also jumped from 8% to over 10% during the same period.

A counterexample is Japan. After the economic bubble burst in the 1990s, Japan fell into deflation, with prices nearly stagnant. People preferred to save rather than spend, and GDP growth turned negative. Japan then entered the “Lost Thirty Years.”

Major economies like the US, Europe, the UK, Japan, Canada, and Australia set their target inflation at 2%-3%, while most other countries aim for 2%-5%.

Who benefits most from inflation? People with debt. It may seem that money devaluation is a loss, but borrowers actually benefit because the real value of what they owe shrinks. For example, if you borrowed 1 million yuan to buy a house 20 years ago, with a 3% inflation rate, that 1 million would be equivalent to only about 550,000 yuan today. You only need to repay roughly half the original amount. During high inflation periods, those who purchase assets (real estate, stocks, gold) with debt see the greatest gains.

The dual impact of inflation on the stock market

In conclusion: low inflation benefits the stock market, high inflation harms it.

In a low inflation environment, hot money flows into stocks, pushing prices higher. During high inflation, governments adopt tightening policies, putting downward pressure on stock prices.

The 2022 US stock market is a typical example. In June, the US CPI rose 9.1% year-over-year (a 40-year high). The Federal Reserve began aggressive rate hikes in March, raising rates a total of 7 times by 425 basis points throughout the year, from 0.25% to 4.5%. High interest rates hurt corporate financing ability and valuations, leading to the worst performance in 14 years, with the S&P 500 dropping 19% and the Nasdaq falling 33%.

However, during periods of high inflation, the stock market does not necessarily collapse entirely. Energy stocks performed well; in 2022, the US energy sector returned over 60%, with Western Petroleum up 111% and ExxonMobil up 74%. This is because oil prices also rise with inflation, significantly increasing energy companies’ profits.

Asset allocation list for inflationary times

During inflation, holding a single asset can be easily eroded. Investors should build a diversified portfolio to hedge against the decline in purchasing power.

Assets that perform relatively well during inflation

• Real estate: During inflation, ample market liquidity often flows into real estate as a store of value, pushing up property prices.
• Precious metals (gold, silver): Gold has an inverse relationship with real interest rates (real interest rate = nominal interest rate - inflation rate). The higher the inflation, the better gold performs.
• Stocks: Short-term performance varies, but long-term returns usually outpace inflation.
• Foreign currencies (USD, etc.): In high inflation environments, the Federal Reserve adopts a hawkish stance, strengthening the US dollar.

Allocation suggestions

A simple approach is the “three-part split”: 33% stocks, 33% gold, 33% US dollars. This allows you to enjoy the growth potential of stocks, the hedging properties of gold, and the inflation-hedging effect of the US dollar, while effectively diversifying risk across assets for more stable returns.

Investors can adjust proportions based on their risk tolerance and time horizon, but the core principle is not to concentrate all funds in a single asset.

Summary: Investment wisdom in inflationary times

Inflation is a phenomenon of rising prices and currency devaluation. Low inflation promotes economic growth, while high inflation requires central banks to raise interest rates to counteract it. However, rate hikes come at the cost of economic slowdown.

The key is to recognize that inflation impacts different groups differently. People with debt, energy company shareholders, and gold holders can benefit from inflation. Ordinary investors should diversify their holdings across stocks, gold, US dollars, and other assets to protect their wealth during inflationary periods.