HOW WILL GOLD PERFORM DURING DEFLATION?

Despite being a highly misunderstood asset (in my opinion) regular readers know I have no hatred of the yellow metal.  In fact, I love any asset that has potential for appreciation regardless of its tangible “value”.  Like a good view, this precious metal carries a certain intangible value.  Of course, as a form of currency, I think investors are sorely mistaken, but that doesn’t mean it won’t continue to act like a currency as I am in an overwhelmingly small minority who believe a return to gold as a currency is nothing short of absurd.  Nonetheless, in the midst of this endless deflation vs. inflation debate I did a bit of homework on gold’s performance during deflation (since we all know it will outperform in an inflationary period).  The results were a bit surprising.

Gold performance during deflation is difficult to come by since it’s such an unusual event, but JP Morgan did a bit of time traveling back to the Great Depression to study the price action in silver (since gold prices were fixed):

“How can the decreed gold price of the 1930s help us now that the gold price is floating? We decided to seek a proxy. Until relatively recently, silver was a partner monetary metal to gold, with very large tonnages in circulation. The advantage of silver is that a market price is available for the 1930s.”

What they found was interesting.  Silver performed well in relative terms:

“Figure 7 shows how, after peaking in 1929, the DJIA 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 its repricing to $35/oz in 1934. This seems to suggest that even after a very tough pre-Keynesian (deficit spending) deflation, the bounce back significantly helped the precious metals. With modern economists already pointing to the money presses as the best medicine against deflation, any postdeflation precious metals bounce is likely to be more vigorous.”

Interestingly, commodity linked metals were not so fortunate.  Copper prices, being very economically sensitive, performed more in-line with equity prices:

“As a check, we also looked at copper’s performance during the depression to differentiate between monetary and commodity metals. However, this test showed that copper’s price performance was very similar to that of the Dow.”

All of this bodes well for gold and silver prices in a deflationary period (as early 2010 has clearly shown us):

“The performance of silver gives us confidence that precious metals are likely to outperform the general markets in a downturn. In a really tough deflation, the absolute price levels of the metals could weaken, even as they outperform most other sectors.”

Updated: It should be noted that the recovery in silver prices were primarily due to government intervention as opposed to natural market forces.  Therefore, the period prior to 1932 is a better proxy for silver price performance, which, was still down dramatically.  On a relative basis (compared to equities), however, silver prices clearly outperformed.  Sorry for any confusion.

Source: JPM

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Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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