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Investing in Gold ... at Any Price?

Inflation is best viewed as something that, in reasonable amounts, can help deliver healthy economic growth and keep an economy on an even keel. Too high, and it erodes the value of the pound in your pocket, undermining confidence in the banks that hold your savings. Too low and it can result in a downward spiral that was last seen in the Great Depression.

Economists often consider a rate of inflation around two per cent as a good target rate, as this suggests prices in an economy are rising gradually. Demand is stimulated as people are more likely to bring forward spending to save money if prices continue to rise.

Times of economic dislocation, however, do much to disrupt the levels of inflation and our broader economic goals as a nation. But gold is at hand, as a means of protecting wealth, while other assets become worthless or overvalued.

Deflation - lessons from history

On the face of it, deflation might sound ideal. It means that price levels at one point are lower than at the same point the previous year. Each pound you spend becomes worth that bit more than before, as the value of everyday items drops. But deflation is often a symptom of some imbalance in demand, where there are simply not enough pounds being spent on a fixed amount of goods.

Retailers often slash prices, as they are currently doing during the lockdown, as a sign that demand for their products is too low. If you aren’t willing to buy a computer or some other product at one price level, the intention of slashing prices is to spur demand, as you might be lured in to buy the item at a discount.

The only problem with this model is that, if everyone takes a ‘wait and see’ approach, holding off spending, as they wait to see if things get slightly cheaper before actually buying, prices continue to drop, and consumer spending remains weak. If consumers delay spending in this way, businesses make less income and have less to pay in wages, reducing take home pay. The cycle perpetuates, as low-paid workers are less willing to make large purchases, causing falling prices and sluggish growth.

Japan and the US have both experienced this exact deflationary spiral before. The US saw this first-hand in the Roaring Twenties, while Japan experienced the bursting of an asset price bubble in 1990. A crash in the stock market led to the loss of capital, causing demand to fall in the housing market, bursting a housing bubble. The destruction of wealth fed into weak consumer spending and a deflationary mood became entrenched.

Unwise investments during the bubble years in both 1920s America and 1980s Japan led to excess speculation and mounting debt. When assets such as houses and shares in businesses crashed in value in the 1930s and the 1990s, the incentive to borrow and spend became far less appealing, while debts remained outstanding.

Post-COVID 19 deflation?

One of the signs of deflation is already apparent, during the current lockdown. Share prices crashed in March 2020, erasing millions of pounds worth of investments that had accumulated over a number of years. Money that could have generated future spending in the economy has now been permanently lost and that means many more millions of pounds worth of wages and further spending may never happen down the line, if you consider the potential multiplier effect of each pound spent.

Another sign of deflation manifests itself in the inflation of the bond market. Yields on government debt have an inverse relationship to the value of government debt. The lower the yield, the more valuable government debt becomes. In the UK, an investor is hard-pressed to find a yield much higher than 0.5 per cent, even on debt which matures in 2070. The lack of potential future gains suggests to some that the bond market is overly inflated, prompting investors to look elsewhere.

If interest rates are to remain near zero for the foreseeable future, there is little reason to expect significant yields to return to the bond market, locking in a deflationary mindset. Japan has been an early adopter of this low-interest low-yield approach, and it has so far done little to eliminate deflation. The UK could easily go down the same path in the 2020s, limiting the scope for future economic growth or inflation.

Gold could benefit from this enormously, as prices were estimated to have doubled during the 1930s, when the Great Depression was at its height and deflation was rampant. Prices currently sit close to £1,400 per troy ounce, having doubled since 2015. Therefore, it isn’t impossible to imagine prices reaching £2,800 or even £3,000 by 2025, if this trend is to continue.

Gold as a hedge against stagflation

Anyone who lived through the 1970s will recall how double-digit inflation occurred so frequently that commentators feared of a stagflationary mindset settling in. Trade unions were growing restless over pay increases, as oil prices spiked twice in one decade. Never before had economists witnessed rapid inflation coinciding with a period of stagnation, hence the term stagflation.

Double-digit inflation is anathema to economic growth in the long run, as it risks social cohesion, owing to the way it devalues the pound in your pocket. If inflation ran at 10 per cent per annum for just a decade, one pound at the start of that decade would eventually be worth just 38 pence when those 10 years were up, representing the dramatic loss in purchasing power. If banks keep your savings at a rate that runs significantly below the current rate of inflation, your savings are already losing value.

Gold proved to be a suitable alternative to eroded savings in the 1970s, as prices leapt from just £15 in 1970 to as high as £373 by 1980.

Many have been quick to point to record-low oil prices, as a way of suggesting that high inflation is highly unlikely. This fails to take into account the fact that the UK has seen an unprecedented level of stimulus from both the Government and the Bank of England. This stimulus has manifested in increased spending to support those furloughed during lockdown, as well as an additional round of quantitative easing. Both measures have the potential to inflate the economy by several billions of pounds, as a means to try and prevent deflation taking hold.

By making such a significant cash injection, policy makers could actually risk the opposite taking place. The money supply could increase, putting pressure on the pound, as too many pounds chase too few goods. Supply constraints could be an issue for some time to come, as exporters try to navigate a post-COVID world, as demand could surge after plunging sharply in 2020. With the Bank of England keen to keep rates low for longer, to avoid snuffing out any nascent recovery, and debts being high, it is possible that inflation may be tolerated for some time, as it serves as a way of helping reduce debt burdens over time. Economists often refer to this measure as inflating debt away. Whether it is a successful strategy is yet to be seen, as the economy is still seen to be moving downwards, according to the latest Markit PMI surveys.

Gold as a store of wealth

What makes gold so attractive, irrespective of whether the economy is going through a period of sustained deflation or stagflation? Gold has great intrinsic value, whatever the economic weather, and has a habit of being revalued to the upside during demand shocks, as seen during the oil shocks of the 1970s. The yellow metal had another great bull market during the crash of 2008 and the debt crisis that followed.

While stocks measure the value of businesses that can succeed or fail depending on the economic climate, and bonds measure an ever-diminishing return on government debt, gold shows a consistent upward trajectory, when it comes to price action. Bear markets in gold are often long lasting, but bull markets reward investors for their patience, as they can last up to a decade, based on price performance since the mid-20th century.

If gold’s last major cyclical low was in 2015, and gold prices have already doubled since then, gold could potentially continue to rise in value for another five years at least, based on trend alone. If you haven’t considered investing in gold already, 2020 could be the moment to do so, bull markets in precious metals often display a distinctive exponential price pattern. The leap from £700 to £1,4000 since 2015 may have caught some by surprise, but the next doubling certainly shouldn’t, especially since it could take gold as high as £3,000.

Gold feeds off weak market sentiment, so the longer a crisis persists for, the faster the price can be expected to rise. It can be difficult to time your entry or exit from the gold markets, but by getting in touch with the experts here at the Gold Bullion Company, who know something about how they work, you can time entry to coincide with potentially great gains.

Article Last Updated: Friday, May 15, 2020