Inflation is coming, and your money is losing value! How should investors respond?

The global economic shocks of 2022 have taught us a profound lesson: inflation is no longer a distant economic term but a tangible reality affecting our wallets. The Central Bank of Taiwan raised interest rates five times, and the US inflation rate soared to a 40-year high. All these signals tell us: learning how to find opportunities within inflation has become an essential course for investors.

What exactly is inflation? Why does it occur?

Simply put, inflation is the continuous rise in prices, making your money worth less and less. In economic terms, when the amount of money circulating in an economy exceeds the supply of actual goods, it leads to too much money chasing too few goods, resulting in rising prices.

The causes of inflation are complex and varied. A sudden increase in demand can push prices higher; this demand-pull inflation, while bringing economic growth, also raises consumer costs. Conversely, cost-push inflation caused by soaring raw material costs is even more troublesome—take the 2022 Russia-Ukraine conflict as an example, European energy prices skyrocketed tenfold, leading to an inflation rate in the Eurozone CPI of over 10%, a record high, yet this inflation was accompanied by an economic recession. Excessive money printing by governments and psychological expectations can also trigger inflation cycles.

The most common indicator used to measure inflation is the Consumer Price Index (CPI). In 2022, the US CPI rose 9.1 year-over-year, hitting a 40-year high, enough to illustrate the severity of inflation at that time.

Why do central banks around the world choose to raise interest rates?

When inflation spirals out of control, central banks typically opt to raise interest rates. The logic is simple: higher rates increase the cost of borrowing, discouraging people from taking loans for consumption, and encouraging them to deposit money in banks. Reduced market liquidity and decreased demand for goods naturally lead to lower prices, thus controlling inflation.

For example, if interest rates rise from 1% to 5%, the annual interest cost on a 1 million loan jumps from 10,000 to 50,000, a difference significant enough to discourage consumer spending.

However, raising interest rates also has costs: reduced demand means businesses may stop expanding, layoffs may occur, unemployment rises, economic growth slows, and in severe cases, it can trigger an economic crisis. The US experienced this in 2022—The Federal Reserve raised rates seven times, from 0.25% to 4.5%, resulting in the S&P 500 index falling 19% and the Nasdaq dropping 33% cumulatively.

Is inflation really all bad?

Not necessarily. Moderate inflation can be beneficial to the economy. When people expect future goods to be more expensive, their consumption desire increases, boosting demand and encouraging businesses to invest, which increases production and promotes economic development. China’s experience in the early 2000s is a good example: CPI rose from 0 to 5%, and GDP growth accelerated from 8% to over 10%.

On the other hand, deflation—negative inflation—is the true nightmare. Japan fell into deflation in the 1990s, with stagnant prices, people saving rather than spending, and GDP contracting, leading to the so-called “Lost Thirty Years.”

Therefore, developed countries like the US, Europe, and Japan set their target inflation at 2%-3%, with most countries aiming for 2%-5%, to maintain a balance between economic growth and price stability.

Who benefits from inflation?

The most direct beneficiaries of inflation are those with debt. When prices rise, the real value of what you owe diminishes. For example, if you borrowed 1 million to buy a house 20 years ago, with a 3% inflation rate, the real value of that debt after 20 years shrinks to about 550,000, meaning you only need to repay half the original amount.

Thus, during periods of high inflation, those who purchase assets (real estate, stocks, gold, etc.) with debt tend to benefit the most. This strategy is supported by historical data.

How to allocate assets during high inflation?

Low inflation favors stocks, while high inflation tends to be the opposite. During low inflation periods, hot money flows into stocks, pushing up prices; during high inflation, central banks adopt tightening policies, causing stock prices to fall. 2022 is a typical example.

But this does not mean avoiding stocks during high inflation. Energy stocks often perform remarkably well in such times. In 2022, the US energy sector returned over 60%, with Occidental Petroleum up 111% and ExxonMobil up 74%, far outperforming other sectors.

Besides selective stock allocation, consider the following assets:

Real estate: During inflation, increased liquidity often flows into property, driving up prices.

Precious metals (gold, silver): Gold inversely correlates with real interest rates. The higher the inflation, the lower the real interest rate, and the better gold performs. It is a classic asset for hedging against inflation.

Foreign currencies (e.g., USD): During high inflation, the Federal Reserve adopts hawkish rate hikes, boosting the US dollar.

Stocks: Although short-term performance may vary, long-term returns generally outpace inflation.

A scientific asset allocation plan could be: 33% stocks (especially energy), 33% gold, and 33% USD. This approach leverages stock growth potential, gold’s preservation of value, and USD’s hedging effect, while reducing risks associated with any single asset class, providing more stable investment returns.

Summary: Investment wisdom in the face of inflation

Inflation is both a challenge and an opportunity. Understanding its causes and effects, keeping abreast of central bank policies, and building a diversified portfolio are the right strategies to cope with inflation.

Low inflation drives economic growth, while high inflation requires central banks to wield the interest rate sword—double-edged. Smart investors should preemptively position themselves based on inflation expectations, using a mix of stocks, gold, USD, and other assets to prevent cash from losing value and to seize market opportunities. In an inflationary era, staying alert and flexible is key to growing assets rather than shrinking them.