Inflation or Deflation? – Why Gold Could Shine

Where there is an economic crisis, there is always some major shift in inflation that follows as a direct consequence. In the 1930s, the collapse of the post-World War One economic bubble in the United States resulted in mass unemployment and mass deflation in many nations.

Fast-forward to the 1970s, and the post-World War Two economic boom gave way to two oil shocks, double-digit inflation, rising trade union discontent and a general sense of malaise and stagnation. A prevailing deflationary pressure has emerged worldwide since the 2008 global financial crisis, with occasional spikes in inflation and commodities.

Inflation often serves as a lagging indicator to past economic performance, but that shouldn’t minimise the effect that inflation and deflation can have on a society in the long-term. The current COVID lockdown could create a complicated picture when it comes to inflation, due to the unprecedented scale of economic disruption involved. We look at the future here and what all this could mean for the gold price.

Deflation and Japan’s Lost Decades

Persistent deflation is often a common symptom of insufficient demand within an economy, as the demand for goods and services remains so constrained that businesses feel pressured to cut costs to try and incentivise a shift in consumer behaviour. The Great Depression of the 1930s saw deflation hit the US and Europe, after the bursting of an asset price bubble in stocks coincided with weak economic performance.

The loss of capital following the 1929 Wall Street Crash effectively swallowed up millions of Dollars which never came back. A domino effect on consumer demand followed and ultimately we saw inflation in the global economy.

Japan’s much-documented Lost Decades from 1990 to 2009 marked a prolonged period of weak growth, low demand, which resulted in a persistent deflationary mood. The Lost Decades followed the bursting of an asset bubble which formed in Japanese house prices and Japan’s own stock market.

When the value of assets declined across the board, economists such as Richard Koo theorised that outstanding levels of household and corporate debt had grown so large that consumers and businesses spent the next 20 years feeling they had no choice but to pay down debt, rather than invest or spend. Two decades of deleveraging caused Japan’s economy to grow at a fraction of the rate it used to achieve during the country’s bold post-war economic boom.

Many attribute emergency measures such as fiscal stimulus and quantitative easing as some of the few engines of growth, which helped Japan avoid slipping into a full-blown great depression of its own in the 2000s. In the meantime, price levels had to adjust accordingly, with retailers cutting costs to attract customers. In turn, customers themselves may have helped feed into a deflationary spiral by reducing spending, in the expectation that prices would fall even lower by some future point.

Could deflation be on the cards?

The recent turmoil following the start of the COVID-19 pandemic could potentially result in a future resurgence of deflation, as the US and UK have seemingly followed Japan’s own path. Share prices have fallen, demand is stifled by lockdown measures, but debts still have to be paid. When the UK emerges from lockdown, this demand shock, coupled with overall indebtedness could result in further deleveraging in the UK.

Some of the early signs that a more deflationary environment could be on the verge of taking root include the fact that bond yields have fallen close to zero in the UK, having drifted lower and lower since the early 1980s. Bonds are a good metric to determine the path of inflation in an economy, as investors are paying money to invest in government debt, expecting to be paid at a rate of interest over a fixed term, which beats inflation, so they can make a profit in the long run.

At the latest count, yields on UK government debt are firmly below 0.5 per cent, extending as far out as 2070. This means investors should expect limited returns on such investments for a considerably long period of time. Low yields on bonds suggest that inflationary pressures are weak, and that the value of debt is value, making it less affordable for others to consider investing.

Alex Mashinsky, CEO of cryptocurrency platform Celsius Network, claimed in a recent article that an inflated bubble in the US bond market could propel US gold prices to as high as $3,000 per troy ounce by late 2021, as the treasury market becomes increasingly crowded and returns diminish.

If the malaise persists in stocks and shares, investors may have no choice but to turn to gold in this desperate hour. The precious metal has shown consistent strength, as the UK has endured a number of deflationary shocks since 2008. In pound sterling terms, the price of a single troy ounce of gold has doubled since 2015, beating the performance of the stock market, and outshining even the bond market.

Stagflation and the case for gold

If inflation is a coin, deflation is one side and stagflation is the other. For much of human history, prices were volatile, as many people lived at subsistence level, generation after generation. One year, prices could be stable, only to surge due to natural disasters, famine or war the next, before dropping sharply when things returned to some new normal.

The concept of low stable inflation, in that sense, is a fairly novel idea. Stagflation as we know it entered into the English language sometime during the post-World War Two economic recovery. Linguistically it was a close relation to deflation, with inversely devastating effects. If deflation reflects a chronic shortage of demand, stagflation reflects a severe lack of supply, outstripped by an unsustainable level of demand.

One of the most accepted economic theories is that a fall in the supply of the typical commodity combined with a steady or rising level of demand will inevitably result in a rising price over time. Scarcity increases the unit value of an item, as people show greater will to pay more and more to secure a share of an item, commodity or precious metal.

The last great period of stagflation experienced in the UK occurred in the 1970s, in the midst of upheaval caused by two oil shocks and growing discontent among trade unions. Disruption to the supply of oil crippled the UK economy, sending petrol prices to new all-time highs. Fearing a loss of disposable income, unions argued for higher wage increases, to keep ahead of a rise in inflation.

The trouble is, ever increasing wages themselves feed into higher inflation down the road, as higher salaries can only be paid for if businesses charge more money on the goods and services they provide. The 1970s episode of stagflation experienced in the UK shook British politics to the core, and either directly or indirectly led to at least two recessions, before prices started to rise at a more sustainable rate.

Many may have observed how the COVID-19 crisis has led to a fall in the value of commodities such as oil, and based on historical evidence, this would imply that price pressures may ease, reducing the likelihood of runaway inflation. However, what might not be accounted for is the unprecedented scale of fiscal and monetary easing that has been undertaken by policy makers at the Treasury and the Bank of England.

High public spending redistributes taxed income back into the economy, and any fiscal stimulus, including tax cuts and more generous Government benefits from Chancellor Rishi Sunak could lead to more money ending up in the typical Briton’s pockets, which has to be spent at some point. In addition, monetary stimulus from the independent Bank of England, such as quantitative easing and recent interest rate cuts, means that borrowing has never been cheaper.

Gold as a store of value

Higher public spending, cheaper borrowing costs plus a potential boost in the money supply, through billions of pounds of quantitative easing, could all ultimately cook up a new inflationary mix, which elevates prices in the near future. The consequence of this would be a weaker pound, and gold has traditionally outperformed most assets when the pound has been under great pressure from sellers.

In 1970, gold was worth barely £15 per troy ounce. Following the first oil shock in 1975, it had grown to £83 per troy ounce. By 1980, prices had soared exponentially to a new all-time high of £371 per troy ounce. This rally in prices was only possible, due to the persistence of double-digital inflation in each year of the 1970s, as well as the geo-political shocks such as the surge in oil prices and Cold War developments including the Soviet invasion of Afghanistan.

History can only tell us so much, and is never indicative of precise future returns. But we can piece together an emerging pattern that gold prices rise during bouts of deflation and stagflation. If the stock market provides something of a useful metric to measure how parts of the UK economy are doing, the recent slide in share prices suggests a downturn or recession is highly likely.

The bond market continues to inflate, with yields collapsing to such a low level that most of the gains to be had have already occurred. If they fall any further, yields will turn negative, making bonds actually generate losses for investors, something that undermines how the bond market is supposed to operate, at least based on historical performance.

What better way to ride out the storm in 2020 and beyond, than by investing in gold? It has great intrinsic value, and bull markets can last a number of years, with the greatest gains observed in parabolic price actions towards the latter stages of a bull run. Gold prices just hit a new all-time high topping £1,400 per troy ounce, and it is unclear when the current malaise will be resolved, and what it will mean for prices. Protect the value of your money by investing in gold, one of the greatest historical stores of value.

If you would like to learn more about investing in gold, get in touch with UK Bullion today. Despite the recent disruptions to supply chains and delivery services, we are now regularly replenishing stock and deliveries to our customers have resumed.


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