How to hedge against deflation

Falling consumer prices? It doesn’t even seem conceivable where we are today in the midst of an energy crisis.

But look 12-18 months into the future and its not such a difficult thing to imagine.

But first, where have we seen deflation in the past? Consumer prices tend to be quite sticky in the sense that higher prices tend not to reverse. It is very uncommon, at least in modern times, for the overall price level to swing between inflation (a period of rising prices), and deflation (a period of falling prices).

Periods of deflation occurred much more frequently in the past. The two characteristics that defined those periods were a) when the economy was dominated by agriculture and b) during episodes of conflict between nations and civil war.

The former contributed to frequent swings between times of plenty where food prices were low or falling, and times of scarcity when food shortages resulted in rapidly increasing prices.

The latter meanwhile tends to result in a period of high inflation as governments print money to fund the war effort and shortages of basic goods develop. This boom often turns to bust sometime thereafter the war comes to an end, taking prices down with it. Note that the imposition of price controls have tended to mute the inflationary impact of war until after the war has ended and the controls are lifted.

The post pandemic economy features both of the characteristics that have been present in past episodes of deflation.

The economy is no longer dominated by agriculture, but for the first time in many years we are experiencing periods of shortages followed by gluts across multiple, interconnected markets. Secondly, governments and central banks have pumped money into the economy to stave off the worst of the economic fallout from covid-19 lockdowns for which we are experiencing the inflationary impact right now.

It’s not that deflation is the expectation, simply that the risk of it occurring is probably higher than what people are discounting. That’s why it’s important to always invert and see the potential for the other side of the bet to materialise.

Lets first look at gold’s role.

Gold is more commonly associated with it’s role as a hedge against inflationary expectations, but it’s much much less known as a hedge against a prolonged period of declining prices. In fact, historical data indicates that gold preserves purchasing power even more effectively during a period of deflation than it does during an inflationary episode.

In his book, “The Golden Constant”, author Roy Jastram examined gold’s performance over a series of inflationary and deflationary periods, going as far back to the 17th century in England. Over the past four centuries, gold lost its purchasing power in every period of inflation; by anything from 21 percent (in both 1675-1695 and 1752-1776) to 67 percent (1897-1920). In contrast, in each of the four deflationary periods since the 17th century in England, gold has increased its purchasing power, by between 42 percent (1658-1669) and 251 percent (1920-1933).

Although there is still an opportunity cost in holding gold during a period of deflation, gold appears to gain in value in part due to its role as a bearer asset independent of the financial system.

More recently, investors must also consider the reaction function of central banks in their decision to own physical gold. If the technocrats in charge of the central bank money printer sense the slightest risk of deflation they will pump enormous amounts of liquidity into the economy.

No amount is too extreme if it avoids a deflationary debt doom-loop, at least in the eyes of central bankers. If investors are confident in how authorities react then the best assets to own when there is surplus money swashing around are scarce assets.

To hedge against deflation it pays to own scarce assets. That means gold and other precious metals, and it also probably means crypto (bitcoin and eth) and technology stocks too.

Related article: Is it time to short the ‘shortage economy’?

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