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Why Gold Is an Excellent Deflationary Hedge

By Ivan Martchev - Updated Apr 6, 2017 at 2:49AM

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Gold is famous as an inflation hedge, but it works just as well in deflation.

Deflation is here now -- and it may be with us for a while. Uninformed observers contend that the central bank has an unlimited capacity to print money, hence deflation can be avoided, but as we can see by the collapse in housing prices and the inflation indexes of late, this is easier said than done.

Last month, I wrote a short piece on deflation, but I think the topic deserves more time.

Cash for gold
If you've not read the entire "helicopter" speech by Fed Chairman Ben Bernanke, I encourage you to do so. (It's available here.) The speech provides more details on deflation, but Bernanke also compares the U.S. dollar to gold:

What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

Now, in my view, it is the very collapse of the credit mechanism that has resulted in this deflationary cycle, and printing money will not be able to compensate for it for some time. Money and credit are not the same things. You can give the banks all the money in the world, but if they don't lend it, it will not make much difference.

Why did gold touch $1,000 an ounce this month if we have falling prices? Wasn't gold a classic inflation hedge?

Here's the thing: Gold is an asset, not a liability on anyone else's balance sheet. Remember the Primary Reserve fund? Lehman Brothers' short-term bonds (i.e., liabilities) were the fund's assets. When Lehman blew up, so did the fund. This would never have happened if the fund held gold bars as assets; they are no one's liability.

Bullion vs. stocks
In my opinion, the most egregious error investors make is to use gold stocks as substitutes for gold bullion. They are not the same thing.

Gold stocks are financial assets that have claims on gold bullion, while gold bullion is a real asset that, again, is not a liability on anyone else's balance sheet. In deflationary 2008, gold bullion was up 5.8%, while the larger-cap PHLX Gold and Silver Index (XAU) was down 27.7%. This was driven by fund liquidations because of investor redemptions, resulting in gold stocks' cheapest valuation since the bull market began in 2000 in relation to the price of gold. You can see that by simply dividing the value of the XAU index and the gold price.

Since the central bank has embarked on quantitative easing, much as was outlined in Bernanke's helicopter speech, I expect more dollars to chase a finite supply of gold for some time to come, even in a deflationary environment caused by tight credit conditions. This is likely to put upward pressure on gold prices.

Gold bullion is investable through the SPDR Gold Shares (GLD), which trade at one-tenth the price of gold and will deliver nearly identical performance. For those who can take the risk, there is a new product called the Deutsche Bank Double Long Gold (DGP), which delivers double the monthly performance of gold bullion. But keep in mind that while the GLD is an exchange-traded fund that holds physical bullion, the DGP is an exchange-traded note (ETN) that holds no bullion. Instead, the DGP is a liability of Deutsche to pay double the return of gold to those who buy the ETN. If Deutsche fails -- and it really is too big to fail, as it is the biggest financial institution in Germany -- the ETN is worthless, as was the case with similar ETNs from Lehman Brothers.

Another way to have leverage to the gold price is via the purchase of gold stocks. The Market Vectors Gold Miners ETF (NYSE:GDX) offers a nice broad participation in both large and medium precious-metals producers. Among the ETF's top holdings are AngloGold (NYSE:AU), Barrick Gold (NYSE:ABX), and Gold Fields (NYSE:GFI).

The last time gold was near $1,000 an ounce in March 2008, the GDX was trading near $55. Eleven months later, gold is again near $1,000 an ounce and the GDX is trading near $35, while gold mining costs have declined courtesy of the collapse in the price of oil. Due to the use of heavy diesel-powered mining equipment and many chemicals, the price of oil is a big component of mining costs. In other words, gold stocks look like a great buy on any pullback here.

A great fund that tends to invest in smaller, more leveraged gold stocks is Tocqueville Gold (TGLDX). The fund has about $500 million in assets under management and currently has large stakes in Randgold Resources (NASDAQ:GOLD) and Goldcorp (NYSE:GG). Its expense ratio of 1.44% is right at the category average. The manager, John Hathaway, has been there for 10 years and has done a great job over that period. The bad performance in 2008 is not his fault, so it may be a good time to consider the fund.

Gold tends to do well in financial turmoil -- be it deflationary or inflationary -- and poorly in good times. Since this economic mess is far from over, now's a great time to take a look at getting some.

More on gold:

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Stocks Mentioned

Barrick Gold Corporation Stock Quote
Barrick Gold Corporation
GOLD
$19.04 (1.38%) $0.26
Goldcorp Inc. Stock Quote
Goldcorp Inc.
GG
SPDR Gold Trust Stock Quote
SPDR Gold Trust
GLD
$169.90 (-0.11%) $0.19
AngloGold Ashanti Limited Stock Quote
AngloGold Ashanti Limited
AU
$15.94 (2.25%) $0.35
VanEck Vectors ETF Trust - VanEck Vectors Gold Miners ETF Stock Quote
VanEck Vectors ETF Trust - VanEck Vectors Gold Miners ETF
GDX
$29.47 (-0.64%) $0.19
Gold Fields Limited Stock Quote
Gold Fields Limited
GFI
$9.74 (2.10%) $0.20

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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