Investment logic in an inflationary environment: mastering asset allocation to mitigate the purchasing power crisis

What is inflation? Why does it continue to trouble us?

In recent years, global prices have been steadily rising, and many countries are facing inflationary pressures. Simply put, inflation is a period during which the prices of goods and services continuously increase, leading to a gradual decrease in the purchasing power of cash — in layman’s terms, “money becomes less and less valuable.”

The main indicator used to measure inflation is the Consumer Price Index (CPI). The higher this number, the greater the price increase.

How does inflation form? Four major drivers cannot be ignored

The fundamental cause of inflation is that the amount of money circulating in the market exceeds the actual output of the economy, with too much capital chasing limited goods. Specifically, there are several driving factors:

Demand-pull inflation

When consumer demand for goods increases, it drives businesses to produce more and raise prices. As businesses earn higher profits, they further increase consumption, creating a virtuous cycle. Although this type of inflation pushes prices up, it also stimulates economic growth (GDP growth), which many governments welcome.

Cost-push inflation

Rising raw material and energy prices directly increase production costs. A typical example is during the Russia-Ukraine conflict — Europe faced energy shortages, with energy prices soaring tenfold, leading to an annual CPI increase in the Eurozone of over 10%, a record high. However, this type of inflation often results in decreased economic output and GDP contraction, which governments generally dislike.

Excess money supply

Unrestrained printing of money by governments directly triggers inflation. Many historical episodes of hyperinflation stem from this, such as Taiwan in the 1950s after World War II — at that time, 800 million old Taiwan dollars were only worth 1 US dollar.

Self-reinforcing inflation expectations

Once the market expects prices to rise long-term, consumers will buy in advance, workers will demand higher wages, and businesses will raise prices accordingly, forming a vicious cycle of expectation-action-validation. This is why central banks around the world continuously signal their commitment to controlling inflation.

How does raising interest rates curb inflation? The underlying economic logic

When central banks raise interest rates, borrowing costs increase, and people prefer to deposit money in banks rather than borrow and spend. For example, if the interest rate rises from 1% to 5%, a 1 million yuan loan will see annual interest jump from 10,000 to 50,000 yuan, significantly dampening consumption willingness.

As demand decreases, businesses can only lower prices to stimulate sales, causing overall prices to fall back. However, the cost of raising interest rates is also heavy — companies reduce hiring, unemployment rises, economic growth slows, and sometimes even triggers a recession.

Moderate inflation is actually a “lubricant” for the economy

Many people become anxious when talking about inflation, but moderate inflation can actually be beneficial for the economy. When people believe that goods will be more expensive in the future, their consumption motivation increases, demand rises, and businesses invest in expanding production, accelerating economic growth.

For example, in China, from 0 to 5% CPI growth in the early 2000s, GDP growth also jumped from 8% to over 10%.

Conversely, when inflation rates fall below 0 (deflation), people prefer to save rather than spend, leading to economic stagnation. Japan experienced deflation after the burst of its bubble in the 1990s, ultimately entering the “Lost Thirty Years.”

Therefore, major central banks (such as the US, Europe, UK, Japan, Canada, Australia, etc.) set their target inflation around 2%-3%, with most countries aiming for a range of 2%-5%, which is widely regarded as the “golden range.”

Who benefits most from inflation? Debtors and asset holders reap the rewards

During high inflation periods, cash depreciates, but it is actually advantageous for those with debts. Suppose you took out a loan of 1 million yuan 20 years ago at a 3% inflation rate to buy a house; after 20 years, the real value of that debt is only about 550,000 yuan, meaning your actual repayment amount has effectively halved.

Therefore, during high inflation, those who leverage debt to acquire assets like real estate, stocks, or gold tend to profit the most.

Why does stock market performance vary under inflation?

In low inflation periods, hot money flows into stocks, pushing up prices; during high inflation, central banks adopt tightening policies, which put downward pressure on stock prices.

A typical example is the US in 2022 — in June, CPI increased by 9.1% year-over-year, a 40-year high. To combat inflation, the Federal Reserve raised interest rates seven times, totaling 425 basis points, with the federal funds rate soaring from 0.25% to 4.5%. The rate hikes made corporate financing difficult, compressing stock valuations, and the S&P 500 index fell by 19% for the year, with tech-heavy Nasdaq dropping 33%.

However, during high inflation, energy stocks often stand out. In 2022, the US energy sector returned over 60%, with Occidental Petroleum up 111% and ExxonMobil up 74%, becoming some of the few bright spots.

Diversified asset allocation: Defensive strategies during high inflation

In an environment of high inflation, proper asset allocation becomes crucial. Investors should build diversified portfolios to hedge against the erosion of purchasing power.

Main asset classes that perform well during inflation:

Real estate — During high inflation, liquidity tends to flow into real estate, pushing up property prices.

Precious metals (gold, silver, etc.) — Gold prices are inversely related to 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 generally outpace inflation.

Foreign currencies (such as USD) — Central banks tend to raise interest rates in high inflation environments, leading to an appreciation of the US dollar.

A practical allocation plan is to divide funds into three parts, each accounting for 33%, invested respectively in stocks, gold, and US dollars, fully leveraging the advantages of each asset class — growth potential of stocks, store of value of gold, and inflation hedge of USD — while diversifying risk.

Summary: How to manage investment rhythm during inflation

Inflation is a constant challenge in modern economies. Low inflation promotes growth, while high inflation requires central banks to raise interest rates to contain it. For investors, the key is to recognize that moderate inflation is not entirely negative; more importantly, it is essential to use diversified asset allocation to hedge against currency depreciation risks. Stocks, gold, USD, real estate, and other assets each have their characteristics. Combining these investments wisely can help preserve wealth and achieve growth during inflationary times.