Posted On Wednesday, Sep 22, 2010
Investors feel highly puzzled given the uncertain macroeconomic scenario. There are two schools of thought - either you believe that all the measures undertaken by governments across the globe will work and we will see a return of the ‘Good Times’, or you believe that all these measures will fail and the world will plunge into economic chaos. So investors will be confronted with either inflation (if all the government stimuli work) or deflation (if all the government stimuli fail).
However, given the efforts that all Governmnets are putting in to revive their fragile economies, inflation looks the likely outcome. However, some argue that given the output gap and high unemployment in industrial countries, it would be very difficult to generate inflationary pressures at least in the short run. In such a scenario, the risks remain tilted towards further disinflation.
Most investors agree having gold in ones portfolio is a protection against any adverse economic condition. The protection against inflation thesis has become conventional wisdom emanating more from what wasexperienced during the 1970s. The notion that gold is a hedge against inflation, and conversely been shunned on thought s of deflation.
Gold would be an ideal asset and an effective hedge against both deflation and inflation. Given the current scenario, we are of the opinion that gold remains in a win-win situation irrespective of the likely outcome that unfolds. However, this very idea defies logic because it is not possible for something to be a hedge against one financial outcome and to simultaneously be a hedge against the opposite outcome. It certainly makes no sense to just buy gold and assume that you are going to be fine regardless of whether we get inflation or deflation. However, in today’s scenario, of monetary excesses and the central banks attitude and approach to economic issues solicits an allocation to gold.
Deflation is defined as falling levels of both economic activity and falling price levels on an absolute basis. This contraction of economic activity is generally preceded by an unsustainable boom period and is usually kickedoff by an event which causes loss of economic confidence. In a deflationary scenario, there’s a “dash for cash” as instability increases and credit quality deteriorates. There’s a clear shift of preference from capital growthto capital preservation. To use a nautical example, investors tend to maintain a steady course rather than moving full steam ahead.
When the perceived value of currencies is under question, like it is today, there would likely be an increased tendency to own gold. Both the dollar and the euro have seen sharp declines recently and are losing confidence bythe day. Thus the only ‘safe’ alternative is gold.
Having said that, there is also a possibility of some initial weakness in gold but once it dawns upon masses as to how difficult and painful this deflation would be for over-indebted countries and households, gold prices would likely soar.
The 1930s deflation is a classic case. At that time, gold was closely linked to money. Under such a monetary system, when the purchasing power of the national currency rose as a result of deflation there was a subsequent rise in the purchasing power of gold.
Under the current monetary system gold is not the official form of money. Unfortunately, this means there aren’t any historical examples of how gold performs during deflation when the metal is not the official form of money. However, we can get an idea of what to expect from gold if deflation were to occur now by looking at how silver performed during the 1930’s.
Source: JP Morgan
After peaking in 1929, the DJIA or the Dow Jones Industrial Average fell sharply to less than a quarter of its peak value. Gold, because of its fixed price, was unaffected. Silver fell too, but it significantly outperformed the reported DJIA on the way down. What is also encouraging is that after the deflation bottomed in 1932-1933, silver bounced back quickly, and by 1934 it was higher than its 1929 level. Intriguingly, gold seems to parallel this with it’s repricing to $35/oz in 1934.
Silver performed well in relative terms. If gold was freely traded in the 1930s, it’s performance would have probably been much better that of silver.
There’s one more proxy to get some idea of how would have gold performed during the 1930s depression. We can see how a gold mining stock i.e Homestake mining Co. performed during the period.
Dow Jones Industrial average and Homestake mining
Chart created by GOLD EAGLE Technical Staff (C) 1997 www.gold-eagle.com
Homestake mining really performed well and an allocation to it would have helped to reduce losses on account of the fall in equity markets.
What deflation does is create a change in behavior for both consumers and businesses as prices spiral downwards over time. Businesses are forced to lay off more and more workers and reduce spending as they receive less moneyfor goods sold, and consumers, expecting to pay lower prices in the future, hold off on purchases.
All this ensues into a recession. Therefore, it becomes important to see how gold has performed during periods of recession since gold was liberalized from paper money (after 1971).
Gold in recession post 1971
Source: WGC, Bloomberg
As seen above, there is no set pattern that gold follows in an economic recession. Even the recent slowdown that began in 2008 saw a sharp rally in gold prices.
Deflation can be much more difficult to stop than inflation where central banks simply increase interest rates to stop escalating prices.
It is indeed very logical to expect an increasing demand for gold during period of deflation. As discussed above, most periods of deflation are accompanied by sharp declines in domestic demand and systemic financial sector problems. Governments and central banks are forced to step in aggressively to offset the slowdown in private sector demand and repair the balance sheets of financial institutions. This generally happens through large inflows of paper currency forcibly printed and being infused in the system.
As the supply of currency rises and concerns about debt levels rise, investors fear paper currency devaluation and look for alternative assets to hold. In addition, concerns about financial institutions – and even the government – solvency and counterparty risk raises demand for alternatives to paper currency. In an environment like today’s, when all major economies are facing severe recession, potential deflation, systemic financial sector crisis and the risk of currency devaluation (similar to the situation during the Great Depression), gold seems to be the only viable alternative to paper currencies.
The last remaining official link between gold and the dollar was severed in 1971 and, not coincidentally, deflation hasn’t occurred since that time. This testifies policymakers vow to avoid deflation by way of monetary infusions.
The transformation from disinflation to inflation is a slow process. It not only benefits the first receivers of money but also leads to mal-investments leading to wastage of scarce resources. Inflation would likely spread on the basis of where the liquidity moves and would be seen in varying proportions in different sectors and different parts of the globe. What we are seeing in emerging markets are likely first signs of the inflationary transformation.
Hence, dear investor, hedge your risks with Gold.
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