In theory the argument that gold performs poorly during deflationary environments makes intuitive sense, but in reality this is not an absolute fact. In the following article, I will provide a real-life example that disproves this myth.
Before I begin, there are a couple general points I'd like to make about gold and inflation/deflation:
1. Deflation is a precursor to inflation. Even if deflation truly did cause poor gold returns, most central bankers have proven over the past decade that they will not tolerate even a couple months of negative CPI. This is because the entire financial system is built off the expectation of nominal economic growth, and deflation would lead to massive defaults and wipe out creditors. Therefore, deflation is a precursor to inflation because every deflationary threat has been met with a massive inflationary monetary response.
2. Gold isn't necessarily an inflation hedge. While it does perform well during inflationary environments - particularly periods of high inflation - in my view this relationship is secondary. In my opinion, the primary drivers of gold performance are currency devaluation and safe haven demand. For instance, inflation (as measured by CPI) was higher during the 1980s and 1990s (in comparison to inflation during the 2000s) but gold was in a secular bear market. Clearly there were other factors influencing gold prices - the 1980s and 1990s differed from the 2000s in that it was a period of real wealth creation (and positive real rates of return) for the U.S. economy. Inflation data in isolation may not be a great forecasting method for gold.
2 Examples That Dispel Gold-Deflation Performance Myth
The past 100 years were scarred by two great deflations. First, the U.S. Great Depression is perhaps the most extreme deflationary case. During this time, however, the dollar was pegged to the price of gold so data is somewhat tainted. Regardless, the Depression forced the US to eventually devalue its currency leading to approximately 70% appreciation in gold. Gold outperformed during a deflationary environment.
The second case is the deflationary episode in modern Japan, as shown in the chart below. Over the past decade Japan has been stuck in a long-term deflationary trend with CPI falling consistently (blue line). At the same time, gold priced in yen (red bars) has risen about 300%. (I think the Japanese case is more robust than the U.S. depressionary case because gold prices in Japan were determined by market forces.) Again, gold outperformed during a deflationary environment.
Moral Of The Story?
While inflation/deflation can influence gold prices, I think the evidence shows that the decision to invest in gold shouldn't be solely based on the forecast for inflation or deflation. As with many things related to investing, there is no absolute rule that says that gold must perform poorly during a deflationary environment.