Investment Guide in an Inflationary Environment: From Economic Phenomena to Asset Allocation Strategies

Understanding Inflation: Why Does Money Depreciate

Prices continue to rise, and the purchasing power of cash gradually declines—that’s the phenomenon of inflation. In simple terms, inflation means that the same amount of money can buy fewer and fewer goods. We quantify this change using the “Consumer Price Index” (CPI).

In recent years, Taiwan’s prices have skyrocketed, prompting the central bank to raise interest rates five consecutive times. What economic principle does this reflect? Why can raising interest rates control inflation? And how should investors respond?

The Fundamental Cause of Inflation: Supply and Demand Imbalance

When there is too much money circulating in the economy relative to the goods available, inflation occurs. There are several main causes:

Demand-Pull Inflation
When societal demand for goods increases, companies respond by increasing production, which pushes prices up. As corporate profits grow, they invest and spend more, further stimulating demand, creating a virtuous cycle. Although this type of inflation raises prices, it also promotes economic growth (GDP increase). Governments generally welcome this situation.

Cost-Push Inflation
Rising raw material and energy prices directly increase production costs. During the Russia-Ukraine conflict in 2022, Europe’s import disruptions led to energy shortages, with oil and gas prices soaring tenfold. The Eurozone’s CPI annual growth rate exceeded 10%, hitting a record high. This type of inflation reduces overall social output and causes GDP to decline, which governments try to avoid.

Excessive Money Supply
Unrestrained printing of money by governments directly triggers inflation. Taiwan experienced such a crisis in the 1950s, when the government issued大量貨幣 to cover deficits after the war, causing prices to soar to 8 million法幣 for just 1 US dollar.

Expectations
If people expect future prices to keep rising, they will spend in advance and demand higher wages. Businesses, in turn, raise prices, forming a self-fulfilling cycle of inflation expectations. Once expectations are set, they are hard to reverse, so central banks actively make commitments to control inflation.

Why Does Raising Interest Rates Suppress Inflation?

Raising interest rates increases borrowing costs. When the rate rises from 1% to 5%, borrowing 1 million costs annual interest payments of 10,000 versus 50,000. Higher borrowing costs discourage loans, leading people to save more. Market purchasing power declines, demand for goods weakens, and businesses lower prices to stimulate sales, ultimately reducing price levels.

However, the cost is clear: reduced demand leads to layoffs, rising unemployment, slowing economic growth, and even economic crises. In 2022, the Federal Reserve raised interest rates seven times, from 0.25% to 4.5%, causing the S&P 500 to fall 19% and the Nasdaq to drop 33%.

The Hidden Benefits of Moderate Inflation

Many people fear inflation, but they overlook its positive effects when moderate. When people expect future goods to be more expensive, their consumption increases, and businesses are encouraged to invest further, increasing supply and GDP.

Data from China in the early 2000s illustrates this well: when CPI rose from 0 to 5%, GDP growth also increased from 8% to over 10%. Conversely, when inflation is negative (deflation), the economy stalls. Japan’s economy in the 1990s, after the burst of the bubble, fell into deflation, with stagnant prices leading consumers to save more, resulting in negative GDP growth and initiating the “Lost Thirty Years.”

Therefore, central banks set inflation targets between 2% and 5%. Developed countries like the US, Europe, the UK, and Japan generally aim for 2%-3%.

For individuals, inflation is especially beneficial for those with debt. Although cash depreciates, the real value of debt diminishes. For example, borrowing 1 million to buy a house 20 years ago, with a 3% inflation rate, means that after 20 years, the debt’s real value has fallen to about 550,000, nearly halving. During high inflation periods, those who purchase assets (real estate, stocks, precious metals, etc.) with debt benefit the most.

Stock Market Performance in an Inflation Environment

Low inflation favors stocks, high inflation harms stocks. During low inflation periods, market funds flow into stocks, pushing prices higher; during high inflation, central banks tighten policies, causing stock prices to decline.

2022 is a typical example. In June, US CPI rose 9.1% year-over-year, a 40-year high. To combat inflation, the Fed aggressively raised interest rates, resulting in the worst stock market performance in 14 years. Notably, energy stocks performed exceptionally well.

Historical data shows that in high inflation environments, energy company stocks often perform countercyclically. In 2022, the US energy sector returned over 60%, with Western Oil up 111% and ExxonMobil up 74%. This is because high inflation is usually accompanied by soaring oil prices, directly boosting energy companies’ profits.

Asset Allocation Strategies During Inflation

The key to coping with inflation is diversified asset allocation. Different assets perform differently in inflationary environments:

Real Estate
During inflation, ample liquidity drives funds into real estate, pushing property prices upward.

Precious Metals (Gold, Silver)
Gold’s value is inversely related to real interest rates (real interest rate = nominal interest rate - inflation rate). The higher the inflation, the lower the real interest rate, making gold more attractive.

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

Foreign Currencies (e.g., US Dollar)
In high inflation environments, central banks tend to adopt hawkish rate hikes, strengthening currency appreciation expectations, leading to a significant US dollar appreciation.

Reasonable Allocation Pattern:
Divide funds equally among stocks, gold, and US dollars. This approach allows participation in stock market growth, while benefiting from gold’s preservation of value and dollar appreciation, providing effective risk diversification.

Summary

Inflation is essentially a process of rising prices and declining currency purchasing power. Moderate inflation promotes economic growth, while excessive inflation causes harm. Although raising interest rates can control inflation, the cost is slowing economic growth and rising unemployment.

Investors should recognize that different assets perform variably in inflationary environments. By appropriately allocating among stocks, gold, and US dollars, one can prevent cash from losing value and achieve steady growth amid economic fluctuations. The key is to build a diversified portfolio based on personal risk tolerance, rather than passively waiting for inflation to erode wealth.