NICHOLAS BROOKS<br /><strong>HEAD OF RESEARCH AND INVESTMENT STRATEGY, ETF SECURITIES</strong><br /><br />SINCE the start of the year, the economic outlook has changed significantly and global depression has been averted. However, we are still in a period of deflation, as RPI figures out earlier this week showed. In May, inflation fell yet again in the UK, from -1.1 to -1.2 per cent.<br /><br />So what can investors do in a period of deflation? Those looking for a safe-haven may well think of gold. But while it is known to perform well in periods of high inflation, is it also attractive in a deflationary scenario?<br /><br />Little has been written about this, mainly because there are few examples of global deflation in the past century and the fact that during the Great Depression of the 1930s the gold price was fixed because most countries were on the gold standard, making analysis of gold demand difficult.<br /><br />One way to get an idea of how gold might have performed if it had been allowed to trade freely is to look at how gold appreciated against individual countries&rsquo; parity rates as countries went off the gold standard in the 1931-34 period. The gold price surged against most currencies once they freed themselves from the fixed rate, implying substantial pent-up demand built up during the deflationary years.<br /><br />Under the gold standard, governments were forced to artificially support their currencies to maintain their parity rates, thus restricting their ability to reflate their economies through aggressive monetary stimulus. It was a classic case of the macroeconomic trilemma, where policy makers under an open capital account are able to control their monetary policy or their exchange rate but not both. In fact, many economists directly blame the policy restrictions caused by rigid gold pegs for turning what might have been a modest recession into a severe global depression.<br /><br />Gold demand should logically rise during periods of global deflation because most such periods, including the current one, are accompanied by sharp declines in domestic demand and systemic financial sector problems.<br /><br />Governments and central banks are forced to step in aggressively to offset the slowdown in private sector demand and repair the balance sheets of financial institutions. This generally leads to large injections of paper currency into the financial system and sharply higher government debt levels.<br /><br />While there are no gold pegs to break today, this does not mean that a similar gold price dynamic will not evolve. During the Great Depression, as the pressure on governments to reflate became unbearable, pegs were released and currencies fell sharply against gold, much like water breaking through a dam.<br /><br /><strong>FLEXIBLE RATES</strong><br />In a world of relatively flexible exchange rates there is no dam to break. A more likely scenario is a gradual but steady flow of assets away from paper currencies towards hard assets &ndash; particularly gold &ndash; as governments step-up reflationary policies and their debt levels build. Already this is being reflected in rapidly growing investment demand for gold.<br /><br />Exchange Traded Commodities (ETCs) and ETFs have become one of the main ways for investors and the public to gain access to physical gold. Assets in gold ETCs rose to over $45bn by February 2009, up from less than $5bn only three years ago. Flows into ETCs have continued to build even during periods when the gold price was falling indicating that strategic investors are increasingly using ETCs to build long-term positions in gold.<br /><br />The massive monetary stimulus being injected into world financial systems will eventually find its way into real economies and ultimately into prices.<br /><br />Unfortunately, history indicates that great monetary stimulus is generally followed by rapid inflation increases. Although the lags can be long (and depend on how long it takes for financial institution balance sheets to be repaired), there is a clear link between money growth and inflation. If history is anything to go by, after a period of deflation, the world may swiftly move into a high inflation environment due to the non-standard expansionary monetary policy that many major central banks are engaging in at the moment. If this scenario plays out, gold will likely be a strong outperformer for many years to come.