Economists and strategists are now starting to warn about stagflation, which combines a stagnant economy with inflation. While the number of disappointing economic reports continues to grow, it’s also looking like inflation is less transient than the Federal Reserve has claimed.
So what happens to gold prices during stagflation? Such an environment is usually good for the yellow metal, but there’s much more than meets the eye this time around.
Data Indicates Stagflation
Economic growth was roaring along in the first half of the year, but more recently, it has slowed while inflation has taken off. Economic data started disappointing in August as inflation data points surprised to the upside.
The World Gold Council attributes much of the economic weakness to fears about new Covid-19 variants and global supply shocks, which are also contributing to growing inflation. Other factors driving inflation include increased commodity prices, worker and parts shortages and problematic global distribution. Inflation has now risen to multi-decade highs. The combination of slowing economic growth and rising inflation suggests stagflation for the current quarter.
The council noted that since the pandemic began, the economy has already moved through all four phases of the business cycle, from goldilocks through stagflation, deflation and reflation. The goldilocks and stagflation periods early last year were mild, but the deflationary and reflationary periods later in the year were sharp.
How Assets Fare During Stagflation
Between the first quarter of 1973 and the second quarter of 2021, gold was the clear winner of the major asset classes during stagflationary periods. Other defensive assets and real assets also did well, but not nearly as well as gold.
For example, the problem for Treasuries is that they face a tug-o-war during stagflation between the negative impact of inflation and the positive impact from the flight to safety. Corporate bonds did worse than Treasuries, although they were still in the green during stagflationary environments.
The World Gold Council believes that fixed income did well because equities did so poorly during stagflationary periods. It noted that average equity returns during times of stagflation had been the worst during such times. Equity investors are squeezed by rising costs and falling revenues.
Gold does so well during stagflationary environments because it benefits from the elevated risk environment, high inflation and falling real interest rates. Interestingly, the U.S. dollar is usually strong during stagflation, which is normally bad for gold. However, a stagflationary environment creates the perfect combination of factors to drive strong performances in both gold and the dollar.
The Last 2 Decades
Over the last 20 years, gold, global broad bond indices and inflation-linked bonds are the only assets to offer positive returns across all four economic phases. However, the World Gold Council states that gold’s annualized average weighted returns in U.S. dollars are often double those of bonds.
If stagflation does occur, the consensus calls for it to be short-lived. Real GDP is expected to accelerate during the fourth quarter amid slowing infections with the delta variant and pent-up demand to support economic growth.
However, the World Gold Council expects prices to remain “sticky” due to the ongoing supply chain issues, which it doesn’t expect to be resolved anytime soon. If consensus ends up being correct, reflation could resume in the fourth quarter, bringing both inflation and growth.
Reflation tends to be positive for risk assets, driving especially strong returns for commodities and equities. Gold usually does well during reflationary environments as well. However, Treasuries usually do poorly during reflation.
Gold in 2021
The World Gold Council noted that gold prices haven’t benefited from record-low real rates this year, which has been a concern for investors. Treasury yields have climbed more than 50% since January, but inflation expectations have been rising too, which kept real yields in the red.
More recently, shifting monetary policy has weighed on gold prices. The yellow metal’s price fell almost 4% in September, driven by higher U.S. yields, futures positioning and strength in the dollar. The impact from monetary policy more than outweighed positive demand trends in China and India during the month.
September was the second straight month of declines in the gold price, bringing the yellow metal down 8% year to date. However, gold wasn’t the only asset to decline in September. Treasuries, corporate bonds and stocks all declined last month, and the World Gold Council suggests it was due to deleveraging. Margin debt for equities was at a record high during the second quarter.
Last month, gold prices moved sharply after three major events. The yellow metal reacted positively to U.S. employment data early last month, but that gain was quickly eliminated. Gold jumped on cooler CPI data for August as investors hoped monetary tightening would be delayed, but it again plunged below its support level. Finally, gold gained amid news of the Evergrande situation later in the month, but it failed to pick up momentum again.
The World Gold Council also noted apathy toward the yellow metal in the futures market as sentiment via long positioning on COMEX turned more and more negative throughout the month. Gold exchange-traded funds had another month of outflows, although it was less than in August.
The council believes that movement in the 10-year Treasury yield as measured by opportunity cost was one of the main drivers in gold’s weakness last month. However, the metal didn’t have much of a reaction when yields rose nearly 25 basis points in the last week of the month.
What All This Means for Gold Going Into Q4
The consensus expects the Fed to start tapering its asset purchases in November, and interest rate hikes could follow close behind. Both moves will likely serve as a headwind for gold, but other factors will impact the price of the yellow metal.
Central banks in other countries are continuing their support, especially the European Central Bank and the Bank of Japan. Additionally, as inflation continues its run, gold should see a benefit as a hedge against a reduction in purchasing power.
“Gold’s performance will likely remain choppy as the markets continue to assess the potential impact of economic indicators on central bank policy,” the World Gold Council write. “The need for portfolio protection and diversification is ever present, but the more optimistic economic outlook could weigh on gold investment and sentiment.”
On the date of publication, the author did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
Michelle Jones is editor-in-chief for ValueWalk.com and has been with the site since 2012. Previously, she was a television news producer for eight years. She produced the morning news programs for the NBC affiliates in Evansville, Indiana and Huntsville, Alabama and spent a short time at the CBS affiliate in Huntsville. She has experience as a writer and public relations expert for a wide variety of businesses. Email her at Mjones@valuewalk.com.