Financial Crisis

The sad truth is that each of us will have to face some kind of crisis at some point. What is important is how we deal with the hardship. We have all heard that the Chinese allegedly use the same word to describe the concept of crisis and opportunity – the idea is that there is an opportunity in every crisis. So let’s identify the opportunities for the gold market hidden in crises.

Financial Crisis and Gold

Financial crisis is a very special kind of an economic crisis, a very dangerous one. It occurs when the value of financial institutions or assets drops rapidly. They are very harmful to the economy, as the recessions which are accompanied by financial crises are deeper by as much as 50 percent. The Japanese economy might be the best example – after the bursting of the asset price bubble in December 1989, the country plunged into a recession that lasted a decade!

Another painful examples are both the Great Depression and the Great Recession. The former was triggered by the stock market crash and was so severe because of the banking panics. The latter started with the bursting of the sub-prime mortgage bubble, which developed later into a full-blown international banking crisis and even sovereign-debt crisis.

As financial crisis is a very severe kind of crisis, in which the confidence in the financial system vanishes, gold likes it the most. Just take a look at the chart below which paints the gold prices during the few most significant financial crises of the 20th century. As one can see, in all cases, the price of the yellow metal actually declined initially. It happened during Latin America debt crisis (1982), the burst of the Japanese stock market bubble (1990), Asian financial crisis (1997), the burst of the dot-com bubble (2000), or the Lehman Brothers’ bankruptcy.

Chart 1: Gold prices (London P.M. Fix, in $) from January 1972 to December 2018.

Gold prices (London P.M. Fix, in $) from January 1972 to December 2018

Hence, investors should remember about two things. First, not all financial crises are positive for gold prices. Financial crises occurring outside the US may actually be quite harmful, as investors shift their funds into the US dollar, which then competes with gold as a safe-haven asset. As the chart above shows, the best period for gold was the first few post-crisis years. As one can see, gold started its impressive rally after the financial crisis began. What is also important here is that it was not merely the stock market crisis (as the dot-com crisis, but a banking crisis as well).

Second, in the very aftermath of the financial crisis gold trading may be quite choppy (see the chart above once more, but focusing on gold’s performance in 2008). This is because cash is king during crises – and gold is often a source of the highly needed liquidity. Hence, when the next financial crisis hits, the gold prices might initially fall before they start to rise.

Silver and Financial Crisis

Although silver has several industrial applications, during financial crises it behaves like gold. As the chart below shows, the price of silver declined when other countries than the US suffered from the financial crisis. However, when the whole globe, including the US, entered into global financial crisis, silver soared (after initial decline). But when the global economy recovered,  silver prices dropped much more than gold prices.

Chart 2: Silver prices (London Fix, in $) from January 1972 to December 2018.

Silver prices (London Fix, in $) from January 1972 to December 2018

Mining Stocks and Financial Crisis

And what about gold mining stocks? Well, although our data series for HUI and XAU indices is shorter, the chart below clearly shows that the price of gold mining stocks also dropped during the non-US financial crises.

Chart 3: Gold mining stocks (HUI Index – blue line; XAU Index – red line) from June 1996 to June 2016.

Gold mining stocks (HUI Index – blue line; XAU Index – red line) from June 1996 to June 2016

However, they are a much worse hedge against the US financial crises than gold and silver. As one can see, their decline in the very aftermath of the Lehman Brothers’ bankruptcy was much deeper, while their recovery much shallower. Actually, in contrast to gold, both indices are currently significantly below the pre-crisis levels (so, they were hit by the recovery of the global economy more than the gold itself, as the falling gold prices narrowed their profit margins).That’s also in tune with one’s intuition - physical metals could be used as money and they have hundreds of years of experience at that. We can’t say the same thing about mining shares.

Precious Metals Sector: Really a Hedge against Financial Crises?

It is usually said that the precious metals serve as a hedge against financial crises and sometimes this role is attributed to mining stocks. The reality is that unless we have a major systemic event (the all-hell-breaks-loose situations like World War III, destruction of major stock and commodity exchanges, etc.), the precious metals sector may not live up to these expectations. Gold and silver may provide some protection in case of a US financial crisis, but the positive reaction in both could be delayed, just like it was the case in 2008. In case of mining stocks, the protection is likely to be weaker.