Back to basics - Higher risk aversion will change risk premia

When there is greater downside uncertainty, there is an increase in fear. We can say that fear in a formal sense is an increase in risk aversion. An increase in risk aversion will have a negative impact asset prices like an increase in volatility. There is some subtlety with how risk aversion impact prices but there is a general acceptance that risk aversion is countercyclical and will impact equity premia.

An increase in risk aversion is manifested through caution, higher avoidance of risk-taking, greater emphasis on safety, and hoarding of safe and necessary assets. In this case, there is increased buying of Treasury bills, hand sanitizer, and toilet paper. 

We have discussed the repricing of risk (see The week the financial world changed - A repricing event), but there is also a resetting of risk aversion in both our real and financial lives. Everyone will be avoiding crowds and being more careful about health. This is all for the better, but it will also translate into different financial risk-taking and will change the behavior of markets. Simply put, more return will be necessary to hold risky assets. There will no longer be a reach for yield but a demand for risk compensation. Instead of asking for yield, there will be an asking for compensation.

Risk aversion also increased during the Financial Crisis, but the Fed and government were able to shift behavior through flooding the market with liquidity and use regulation to increase confidence. Government will be needed again to bend risk aversion, but the policy responses will have to be significantly different. Liquidity without health certainty will be ineffective. Real economy fiscal support without pandemic dampening will only be marginally effective.