When in doubt, go to safety

In a risk parity world where investors want to hold a set amount of risk for an asset class,  if there is an increase in market volatility, there should be a decline in market exposures. In an uncertain world where risk is hard to measure, there should be a shift to cash, so no risk is taken. Risks cannot be easily measured, the demand for the safe asset dominates.

We have seen a significant increase in flows to money funds in the last few weeks. Risk has increased as measured by volatility, but there has been a much greater increase in non-measurable uncertainty. We just don't know how the China situation will play-out. We don't know what will be the reaction to a Fed increase or even whether it will occur in September. The direction of the market is not at all clear.

A close look at money fund flows shows that significant increases occurred during the Euro crisis, the Fiscal Cliff, and the Taper Tantrum. These were all periods of underperformance for risky assets. Money flowed out of risky assets and into cash. The market has to adjust in price to this reversal in flows. This is usually short-lived but will have real effects. Leveraging is out. Risk-off is on.