Furthermore, global economies leaning on fiscal stimulus to drive post-pandemic economic recoveries may exacerbate inflation concerns, especially as it relates to the US dollar (USD) outlook. The potential long-term USD weakness may also be supported by the significant increase in the government debt since 2020, with the debt level soaring from US$23 trillion at the start of 2020 to US$29 trillion as of October 31, 2021. Recent passage of a US$1 trillion infrastructure bill in the US alongside additional economic and spending packages will further add to the current debt level, which may add more downward pressures to expectations for the dollar over the medium term. Given the USD’s historically negative correlation with the spot price of gold,13 performance will likely remain a driver for the gold price in 2022. The USD may find short-term support as the Fed seeks to tighten its monetary policy. However, over the longer term, as Europe and emerging markets close the gap to the growth recovery in the US and as US fiscal spending continues, the USD’s upside may be limited.
Theme 4: Mean Reversion in Risk Assets May Spur Market Volatility
As 2021 comes to a close, the spotlight is on the significant run risk assets have achieved this year. Equity market valuations remain broadly stretched with certain segments carrying lofty valuations, while market volatility has broadly remained tame throughout the year. Additionally, low interest rate policies and increased liquidity from monetary policy continue to spur more risk taking in fixed income and credit markets. Given the strong rally in financial markets in 2021, the potential for a cyclical correction, valuation-driven mean reversion, increased market volatility, or an exogenous tail risk has increased in 2022.
Some potential areas of market risk include:
- Elevated equity market valuations may be challenged against tightening profit margins from rising input prices and higher labor costs. This may cause a mean reversion or cyclical correction growth as expectations moderate.
- Corporate bond spreads over Treasuries remain near their 2021 lows.14 The current combination of low risk-free rates and tight corporate bond spreads has made for structurally lower effective yields. An elevated debt burden against a rate tightening cycle could add stress to broader markets and increase volatility.
- Geopolitical turmoil and headlines may spark broader market volatility with market participants closely monitoring several hot spots globally including but not limited to ongoing tensions between the US and China, Russian activity at the Ukraine boarder, and geopolitical instability in the Middle East and North Korea.
- Cryptocurrencies have seen remarkable growth in value and public attention this year driven by speculative interest, but with this quick ascent comes the potential for a market correction that may spill over to broader financial markets leading to increased volatility, particularly as derivatives tied to cryptos continue to generate interest.
This potential for higher volatility may push investors to gold as a potential hedge against heightened market risks. Historically, gold has served investors well against short-term volatility shocks, both moderate and severe, as measured by rising levels of the VIX index (see figure below).15
Historically, Gold Is a Robust Option Against Various Degrees of Market Volatility
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