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Goods and asset price inflation: Out of the frying pan and into the fire

January 28, 2021

reading time: 5 minutes

by Thomas Weibel, guest author

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Houses, gold and art: history and experience teach us that real assets serve as protection against inflation. But there’s a catch, and it’s called asset price inflation.

It is probably the most straightforward law of the market, and it has been around since the invention of money: if many people want the same good, its provider can demand more money for it, and that good becomes more expensive. Almost equally straightforward is the fact that if many goods cost more than before, inflation has set in. Inflation is sneaky: it gradually devalues wages, pensions and savings. One franc, one euro or one dollar will buy less tomorrow than it does today. Inflation is further intensified when an indebted nation puts a lot of new money into circulation all at once. Because money and thus also loans become cheaper, the demand for goods and services increases additionally - meaning that prices rise further. If inflation ultimately reaches dizzying heights, as it did in Germany, Liechtenstein and Austria in the years between the two World Wars, it leads to ruin: the laundry basket used to carry bank notes to the store in 1923 was worth more than its contents.

Real assets as a safe haven

People who are looking to get followers need one thing above all: good investment results over a certain period of time. Above-average returns make it interesting for other investors to observe and follow the movements in their portfolios. Exactly how this kind of “copy-paste” approach is effectuated on the stock exchange depends on the platform. 

Post World War I Germany: Carrying gold to the bank in Berlin during inflation, 1923. © GettyImages, Bettmann
Post World War I Germany: Carrying gold to the bank in Berlin during inflation, 1923. © GettyImages, Bettmann

However, there would appear to be a way out of this cycle: purchasing an expensive asset that ideally also lessens the burden of everyday expenses, such as an apartment or a house. A property is a real asset and, as such, is not exposed to the decline in the value of cash. Investors can count on the fact that the money they have invested will at least maintain its value, if not increase in the long run. Some people take an oversimplified approach with real assets and maintain that real estate, gold, works of art, antiques, watches or jewelry are a good investment because they are not affected by the decline in the value of money.

But there's a problem with this approach. Investing was a good strategy for centuries, but today it has two fundamental flaws. First: people are wealthier than ever before. And second: as enlightened citizens, they are also more knowledgeable than ever before. In other words: in an affluent society, many citizens can suddenly afford to invest, and in an information society, they are familiar with the sensitivities of markets and ways to escape from cash. So here, too, the inflation merry-go-round begins to spin: asset prices rise. And so so-called asset price inflation follows on the heels of conventional goods inflation. In other words, the investor jumps out of the frying pan and into the fire.

Inflation: Three scenarios

So what should investors do? In the first scenario, wealth remains in cash and is thus exposed to inflation. In the second scenario, real assets are purchased, but at inflated prices due to increased demand, which also eats up part of the funds that have been invested. Scenario number three, on the other hand, would be ideal: a person invests before the price of goods rises due to inflation and before the associated increase in demand for real assets; and they sell before the corresponding bubble bursts. With the returns generated, the investor has thus successfully cheated asset price inflation. But because the returns are in the form of cash, goods inflation is once again lurking just around the corner. It is only possible to escape both types of inflation if investments are made at the right time, then sold at the right time and consumption is resumed again at the right time. However, getting this timing right is all too often a matter of luck. There is no cure for inflation, whether with regard to goods or asset prices.

This article has originally been published on the LGT finance blog (German only)

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