Chicago -- (Kitco News) Precious metals and other commodities are seen as go-to investments during inflationary times as investors seek hard assets to store wealth when prices rise, with gold usually receiving the biggest boost.

Gold performed smartly in the late 1970s-early 1980s when inflation was raging and even though nominally current gold prices are far above those levels, adjusted for inflation today’s gold prices would have to trade around roughly $2,250 an ounce (figure based on Minneapolis Fed's CPI calculator)  to match the January 1980 high of $845.

But how do gold and other precious metals perform in a deflationary environment? There’s not as much history to point to on that one, especially when looking at deflation on a global scale, rather than on a per-country basis.

Concerns about global deflation have peppered the financial markets for the past few months and how much of a worry it is often stems from the economic report of the day.

Indeed, sometimes the debate between global growth and retraction can happen with a span of a week, which gives investors pause and is keeping some markets in trading ranges.

In the U.S., at least, the main inflation gauge, the consumer price index, has roughly been flat in the past few months, showing disinflation. Disinflation is decrease in the rate of inflation, and if the inflation rate isn’t high to begin with, it can lead to deflation.

Deflation is defined as a sustained decline in prices and historically prices for assets fall in general. Leonard Kaplan, president of Prospector Asset Management, said gold prices fall, but generally not as much as other asset classes.

Deflation has been seen in other countries – Japan is the example most-often identified – but deflation on a global scale is rare. Nicholas Brooks, head of research and investment strategy at ETF Securities said one cannot compare country-specific deflation with global deflation since investors have options to go elsewhere in the case of the former.

The Great Depression of the 1930s was the last time there was global deflation. It’s difficult to use this period to analyze deflation’s impact on gold because most of the world’s major currencies – including the US dollar - were pegged to gold; price could not reflect underlying demand changes.

One way to get around this issue is to look at how gold priced in various currencies changed as countries de-pegged from gold during the 1931-34 period. Generally the gold price rose sharply, indicated large pent-up demand.  The main reason gold demand rose during deflationary periods, Brooks said, is that deflation is usually accompanied by weak economic growth, real estate and bank problems.

To offset the slowdown and shore up the financial system, central banks are forced to inject liquidity and government fiscal deficits rise, leading to much higher government debt and solvency worries. These policies raise the risk of currency debasement – either through inflation or nominal currency depreciation. That leads investors to buy hard assets to hedge against these risks, with gold generally being viewed as the main alternative store of value.
 
In 1933, with gold-holding dropping to mandatory minimum levels due to strong domestic and external demand, then-President Franklin Roosevelt was forced to confiscate publically held gold at a predetermined price, halt gold exports and devalue the dollar against gold in order to be able to provide the dollar liquidity necessary to stem bank runs and stimulate the economy.

Brooks and other analysts stress there is no reason for this to happen again because there is no link between currencies and gold. Thus,  there is nothing restricting their policy options. Other analysts have pointed out only about 20% of the U.S. gold was surrendered, with much of it sent overseas at the time.

Cash or high-yield debt is often seen as an alternative during deflation, but there are limits to how money can go there. Prospector Asset Management’s Kaplan said currently gold prices are high simply because investors are buying it. “If you have $5 million to invest, where is the money going to go? Are you going to buy a CD at 0.6%? No. A Treasury (note) at 0.2%? No. Gold is going up because people are buying it. There’s no other reason,” he said.

Spencer Patton, president of Steel Vine Investments, believes that the world could see deflation, but thinks gold will be outperformed by other commodities. He doesn’t see gold strengthening, nor does he see it weakening, and he forecast it will trade in a range of $1,100 to $1,300 by the end of the year.

Because of investment demand for gold, Kaplan said he expects that gold prices will continue to rise and could see $1,800, but said once the U.S. Federal Reserve starts to raise interest rates gold’s rally will end. “We know this will end very badly, the question is when,” he said.

James DiGeorgia, publisher of the website Gold and Energy Advisor, doesn’t believe the global economy is in deflation at all and the inflation is the worry, because of the world’s government debt levels. He said he wouldn’t advocate a portfolio of 100% gold, he would suggest 15% as a hedge against sovereign risk and up to 20% for those particularly concerned. He said gold prices could eventually reach an equilibrium level with the inflation-adjusted 1980s levels for gold. But that could take a while.

DiGeorgia recommends physical ownership of gold. For those not needing or wanting actual metal, Brooks pointed out a physically backed gold ETF could do the same, without the security risk and paying for storage. He also said investors gain the liquidity and convenience of a stock exchange and without having to pay a premium over the spot price.

By Debbie Carlson, contributing to Kitco News;dcarlson@kitco.com

Editor’s Note: Meet the Kitco News Team at the upcoming Kitco Metals eConference September 12-13, 2010. A not-to-be missed event featuring Ron Paul, Marc Faber and other industry heavyweights. The eConference is free with Pre- Registration www.kitcoeconf.com.

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