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The ‘gold is bad in a deflationary environment’ myth
Posted By admin On July 10, 2009 @ 3:50 am In Money Watch | Comments Disabled
Friday, July 10, 2009
The fact that gold is an excellent hedge against inflation should have established itself more or less as common knowledge. Investors use it to protect themselves against the erosion of their purchase power. However, the development of gold in a deeply deflationary environment has not been subjected to much analysis. The only relevant period that would lend itself to comparison is the Great Depression of the 1930s. However, those were the times of the gold standard, i.e. the gold price was fixed.
By 1934 the industrial production had fallen by 50%, and the unemployment rate was up at 30%. Governments around the world had to step up their spending drastically and stop the price slump. The Western currencies were gradually depreciating. However, the economic situation the USA was in in the 1930s could not be compared to the current scenario. Whereas the country used to be the big creditor nation, it has now turned into the single biggest debtor.
We can try to establish how the gold price would have developed by analysing the subsequent depreciation of the currencies after abandoning the gold standard. Great Britain depreciated the pound in September 1931 by 52%, and the USA followed by appreciating gold by about 60% in 1933 (from USD 20.67 to USD 35/ounce).
This means that enormous buying pressure had been building up during the period of the gold standard. When in 1933 the gold reserves had fallen to the minimum requirements, President Roosevelt instructed that all private gold holdings be confiscated. All gold exports were discontinued, and the dollar depreciated massively against gold.
Gold shares, on the other hand, were going from strength to strength. The development of the most important gold producer, Homestake Mining, can serve as reasonably approximate series for comparison. From 1929 to end-1935, the share price increased from USD 75 to above USD 500, and dividends totalled USD 130. However, the strongest increase only happened after the period of deflation (1929-1932) and as the sudden onset of inflation (1932-1935). We would envisage a similar scenario for the future. The stability of the gold shares during the general crash on the equity markets was probably due to the fact that the gold price was fixed and the revenues of the producers were therefore stable, whereas all other commodity prices collapsed.
Other gold mining shares outperformed the market at impressive degrees as well. Dome increased from 1929 to 1936 by almost 1,100%, and Battlemountain shares soared by 1,200%. That said, the performance came also on the back of substantially increased resources, higher production, and improved margins.
Gold AND silver have always been the only two metals of monetary importance and also have a highly positive correlation. Therefore it should be possible to resort to the price of silver – which was not fixed – as well for comparison’s sake. In 1931 and 1932 shares fell by 42% and 51%, respectively, whereas silver fell by 8% in 1931 and by 16% in 1932. Gold should have outperformed silver in this environment, given that silver is much more integral to industrial production and gold is influenced by demand that is contingent on the economic cycle to a much lower degree.
Seeing that in periods of deflation, cash outperforms all other asset classes, this should also apply to gold. Especially in an environment of expansive central bank policy, gold is surely a currency of highest quality and should therefore outperform the market. This means that gold seems to be an excellent investment also in times of deflation.
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