Should Gold Investors Worry About Deflation?

It’s been a long-standing debate between two camps: inflation vs. deflation. As one can expect, there are a lot of well-researched opinions on both sides of the issue. Here in late 2015, deflationary forces have gained the upper hand. If they worsen, should gold investors be worried? After all, gold is best known as an inflation hedge; as deflation protection, not so much.

History has shown that conventional wisdom is not always correct. While true deflation is a rare event, each situation is different. Let’s take an honest look at how we think gold may behave if we experience a period of debilitating deflation.

Deflation’s Upper Hand
Over the past year, commodity and energy prices have crashed, some stock markets have experienced meltdowns, and near-zero inflation in the world’s major economies has persisted. Take a look at the extent of deflation in the following assets over the past 12 months (Figure #1).

Fig. #1
Commodities Have Experienced Deflation

Source: EverBank Research Team, based on an analysis of publicly available data from World Bank, IMF, EIA, Thomson Reuters, Federal Reserve.

Much of the commodity complex has essentially crashed. Even “safe haven” gold has struggled against deflationary pressures.

The Consumer Price Index (CPI), too, remains historically low. Here’s the U.S. government’s measure of inflation since the late 1940s (Figure #2).

Fig. #2
Deflation Has Been Rare Through the Years

Source: EverBank Research Team, based on an analysis of publicly available data from the U.S. Bureau of Labor Statistics, St. Louis Federal Reserve.1

Believe it or not, the CPI has been negative only four times since the late 1940s. And, with the amount of debt most of the developed countries carry and continue to pile on – debt is deflationary in nature, after all – further deflation is the most likely route. None of this seems to bode well for the shiny yellow metal.

But, there’s a message for gold investors that is decidedly more positive than these headline numbers suggest. In fact, there are a couple of factors that indicate gold investors could win in a deflationary crisis. Let’s take a look at those factors, starting with the one you probably haven’t thought of.

1) What’s A Bowl Of Cheerios Got To Do With It?
In a true deflationary environment or full-blown depression, all prices would fall dramatically. Everyday consumer products such as, say, Cheerios would be markedly cheaper. But the gold price would fall, too, I hear you say. Yes, it likely would, at least initially. But other factors would be in play.

Remember during the 2008/09 financial crisis that many businesses, assets, and bonds teetered near insolvency. If, for example, General Motors, mortgage loans, and municipal bonds were threatened again, it would push many investors to look for other ways to store their wealth—like gold. In other words, the fallout from deflation could serve as the very catalysts that make gold attractive.

It’s therefore not unreasonable to think that the price of gold will fall less, in relative terms, than consumer prices.

In that instance, gold’s purchasing power would be greater than it is now, even if the price declines. Deflation would lower the price of most goods, such as your morning bowl of Cheerios. So, an allocation to gold could raise your living standard, as each ounce would increase the amount of goods you could purchase.

And, here’s something else you probably haven’t thought of: you’d get a tax deduction for selling your bullion for a loss.2

2) Reaction
Every currency in the world today is “fiat.” That basically means they’re not backed by gold or any other standard. The advantage to this setup is that central bankers can tinker with the price of their currencies during periods of financial stress. Since the financial crisis in 2008, this has clearly been one of their core strategies.

Based on government reactions to date, if we fall into a true deflation, central bankers around the world would likely respond with inflationary policies. Combined with the money printing and other efforts already implemented, the global monetary system could easily tip into the beginning stages of a trend in higher inflation.

And, the greater the deflation, the more extreme that reaction could be. Indeed, the response by central banks could easily trigger inflation, which, in turn, would likely light a fire under gold’s price. Even if we entered a 1970s–style stagflation, I would expect the gold price to still be strong. In fact, it was that condition that led to gold’s biggest bull market in modern history…the gold price rose 2,485% from its low in 1970 to its high in 1980.3

Keep in mind that true deflation will worry central bankers, finance ministers, and government planners, because it threatens, among other things, the stability of the global banking system. They would not sit idly by.

If we get deflation, that would not be the end of the gold story. The reaction by global governments must be considered, and those reactions would likely be inflationary and could lead to improved gold prices.

Investment Conclusions
Like any investment, gold is not a sure thing. Every asset carries some degree of risk, and the repercussions from monetary recklessness remain unknown.

Regardless, these two factors have a clear message for gold investors: do not fear deflation. Gold still has the potential to deliver the kind of crisis protection it has throughout history.

Until the next Daily Pfennig® edition…

Tim Smith
Vice President
EverBank World Markets, a division of EverBank