Inflation Analysis: Investment Strategies in the Economic Cycle

What is Inflation?

Inflation, abbreviated as “inflation,” refers to an economic phenomenon where prices continuously rise over a period of time. When inflation occurs, the purchasing power of the same amount of money gradually declines, in simple terms, money becomes increasingly worthless. The most common indicator used to measure inflation is the Consumer Price Index (CPI), which reflects changes in the prices of goods and services purchased by consumers.

Where Does Inflation Come From?

The essence of inflation is that the amount of money circulating within the economy exceeds the actual demand, with too much money chasing limited goods. The main factors causing inflation include:

Demand-Pull Inflation: When demand for goods increases, businesses boost production and raise prices. As profits increase, consumer spending is further stimulated, creating a cycle. Although this leads to higher prices, it also drives economic growth (GDP). Governments often actively stimulate demand to promote economic development.

Cost-Push Inflation: Inflation caused by rising raw material prices. For example, geopolitical conflicts causing energy shortages can trigger energy price surges, which in turn increase costs across various industries. This type of inflation can lead to decreased economic output and GDP contraction, making it a key target for government control.

Excessive Money Supply: Unrestrained issuance of currency by the government is a primary cause of hyperinflation. Historically, many countries’ inflation crises stem from this.

Inflation Expectations: When people anticipate future price increases, they tend to spend early and demand higher wages. Businesses then raise prices accordingly, entering a self-reinforcing inflation spiral. Once inflation expectations are formed, they are difficult to reverse, so central banks worldwide strive to guide and control inflation expectations.

How Do Interest Rate Hikes Balance Inflation?

When inflation rises, central banks typically adopt interest rate hikes. Raising interest rates increases borrowing costs—loans become more expensive, and savings become more attractive. This reduces market liquidity, decreases demand for goods, and encourages businesses to lower prices to stimulate sales, thereby controlling overall price levels.

However, interest rate hikes also have side effects: increased financing costs for companies, reduced hiring willingness, and potentially rising unemployment. Economic growth may slow down, and in severe cases, lead to recession. Therefore, central banks face a dilemma—balancing inflation suppression with maintaining growth.

Why Is Moderate Inflation Good?

Many people become anxious at the mention of inflation, but in reality, moderate inflation is beneficial for the economy.

When people expect future prices to rise, their willingness to spend increases, boosting demand and prompting businesses to expand investment and production, leading to GDP growth. For example, during periods of rapid economic growth, a 2%-3% moderate inflation rate is common.

Conversely, when inflation rate falls below 0% (deflation), people expect prices to decline, leading to cautious spending rather than consumption, resulting in economic stagnation. Japan’s experience in the 1990s is a classic lesson—after the economic bubble burst, the country fell into deflation, followed by a prolonged thirty-year economic slump.

For this reason, most central banks set inflation targets between 2% and 5%, aiming to find a balance between stimulating growth and managing risks.

How Does Inflation Affect Different Groups?

Inflation is not necessarily unfavorable to everyone. People with debt benefit the most during high inflation periods. Although cash holdings depreciate, the real value of debts owed also diminishes. For example, borrowing 1 million yuan for a house 20 years ago at a 3% inflation rate means that after 20 years, the real repayment amount is roughly equivalent to 550,000 yuan in today’s purchasing power.

Therefore, during high inflation, investors who acquire assets (real estate, stocks, etc.) through debt tend to reap the greatest benefits.

Stock Market Performance During Inflation

Low inflation periods are generally positive for stocks, while high inflation periods are negative.

In a low inflation environment, capital is more willing to enter the stock market seeking growth, pushing up stock prices. However, during high inflation, central bank tightening policies increase financing costs, pressure corporate valuations, and cause stock prices to fall.

The US stock market in 2022 is a typical example. That year, CPI year-over-year rose to 9.1%, a 40-year high. The Federal Reserve responded with aggressive rate hikes, raising interest rates seven times, from 0.25% to 4.5%. As a result, the stock market experienced a significant correction, with the S&P 500 dropping 19%, and tech stocks falling even more, by 33%.

Investment Opportunities During High Inflation

Although the stock market as a whole faced pressure, not all assets performed equally. The energy sector often performs well during high inflation.

Historical data shows that in 2022, the US energy sector gained over 60%, far outperforming other sectors. This is because inflation drives up energy prices, boosting the profitability of energy companies.

Asset Allocation Strategies During Inflation

In an inflationary environment, proper asset allocation is crucial. Investors should seek diversified portfolios that can hedge against inflation impacts.

Assets with better inflation resistance include:

Real Estate: During inflation, abundant liquidity often flows into the housing market, pushing up property values. Real estate serves both as an asset and an inflation hedge.

Precious Metals: Gold has an inverse relationship with real interest rates (nominal interest rate minus inflation rate). The higher the inflation, the lower the real interest rate, making gold more attractive. Silver and other precious metals share similar characteristics.

Stocks: Although short-term performance varies, over the long term, stock returns generally outperform inflation, making them important tools for wealth appreciation.

Foreign Currency Assets: During rate hike cycles, strong currencies like the US dollar appreciate, providing an inflation hedge.

Recommended allocation plan is to diversify investments, such as 30% in stocks for growth potential, 30% in gold to preserve purchasing power, 30% in US dollars to hedge currency depreciation, and 10% as flexible funds to respond to market changes. This diversified approach reduces risk from any single asset class and better adapts to inflationary environments.

Summary

Inflation is a common phenomenon in economic cycles. Moderate inflation promotes economic growth, but excessive inflation can cause economic harm. Central banks use tools like interest rate hikes for regulation, while investors need diversified asset allocations to cope. Gold, real estate, stocks, and foreign currencies each have advantages in different inflation environments. A well-balanced allocation can help investors effectively hedge against inflation risks and achieve long-term wealth growth.