Risk-on/Risk-off – Actually start with uncertainty high / uncertainty low

Markets have been talking about moving to risk-on from risk-off positions now that the election is supposedly over, yet that view may change again given the spike in COVID cases and the lack of clarity on macro policies. These risk sentiment switches can come fast, yet the sentiment or desire to hold risky assets should be only one focal point for investors. Risk-on/risk-off sentiment is driven by whether the environment is uncertainty low or uncertainty high. Uncertainty generally drives sentiment. Sentiment usually does not drive uncertainty.

There is no special magic with the risk-on/risk-off or RORO indices often used in the market. These indices are a weighted average or aggregation of market information that reflects risk-taking such as corporate spreads, volatility indices, or the price of safe assets. These indices reflect price sentiment through a single number and are not direct measures of outside factors concerning risk or uncertainty.

The driver of risk sentiment has to come from what is not known, what has been changing, and what is surprising in the market. At this point, uncertainty is still high and current volatility levels do not reflect the wide set of changing alternatives the market may face. Look at some of the key  issues:

• Fiscal policy - Not clear what will be the size or consistency of any aid package.
• Tax policy - Not clear whether there will be a rollback, maintenance of existing policy, or something new.
• Regulation - There will be more regulation, but the impact on different industries is unclear.
• COVID policy - A further lockdown is a possibility that could be offset by vaccines.
• Monetary policy - While guidance states rates will stay low, macro-prudential policies are less clear.

Market prices will reflect changing expectations for this policy of policies.

Claude Shannon states, "Information is the resolution of uncertainty." (See Shannon - information is the resolution of uncertainty to understand trader types and how they deal with uncertainty.) New information will remove the policy uncertainty that we are currently facing and that will convert to changes in market prices. Switches in this policy choice resolution will lead to increases in volatility. Investors should focus on uncertainty resolution and not risk sentiment.