Tag: Uncertainty

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Commercial banking: the emerging risks from the shadow-banking sector

Recently, a flurry of bankruptcies among non-bank financial intermediaries (NBFIs) in the USA has drawn attention to the risks associated with alternative credit channels in the shadow-banking sector – lending which is not financed with deposits. There is concern that this could be the start of a wave of bankruptcies among such NBFIs, especially given concerns about a potential downswing in the economic cycle – a time when defaults are more likely.

While providing alternative sources of funding, the opacity of lending in the shadow-banking sector means it is not clear what risks NBFIs face themselves and, more significantly, what risks they pose to the financial system as a whole. There is particular concern about the impact on regulated banks.

Already, JP Morgan Chase in its third quarter earnings report announced a $170m charge stemming from the bankruptcy of Tricolor, which specialised in sub-prime car financing. Mid-sized banks, Western Alliance and Zions Bancorp, have reported losses from loans to a group of distressed real estate funds. This has highlighted the interconnectedness between NBFIs and regulated banking, and the potential for problems in the shadow-banking sector to have a direct impact on mainstream banks.

In this blog, we will trace the secular trends in the financial systems of more advanced economies which have given rise to alternative credit channels and, in turn, to potential banking crises. We will explain the relationship between regulated banks and shadow banks, analysing the risks involved, the potential impact on the financial system and the policy implications.

What are the secular trends in banking?

The traditional model of commercial banking involved taking deposits and using them to finance loans to households and firms. However, cycles of banking crises, regulatory changes and financial innovation over the past 50 years produced new models.

First, banks diversified away from direct lending to providing other banking services – on-balance sheet activities, such as investing in financial securities, and off-balance sheet activities, such as acting as agents in the sale of financial securities.

Second, alternative credit channels based on financial markets have grown in significance.

In the 1980s, international regulations around traditional banking activities – taking deposits and making loans – were being formalised by the Bank for International Settlements (BIS) under what became known as the Basel framework (see, for example, Economics section 18.2 or Economics for Business section 28.2). For the first time, this stipulated liquidity and capital requirements for international banks relating to their traditional lending activities. However, at the same time the deregulation of financial markets and financial innovation provided banks with opportunities to derive revenues from a range of other financial services.

After the financial crisis, liquidity and capital requirements for banks were tightened further through the Basel III regulations. Commercial banks had to have even higher levels of capital as a buffer for bad debts associated with direct lending. A higher level of capital to cover potential losses increases the marginal cost of lending, since each pound of additional loan requires additional capital. This reduced the marginal return, and consequently, the incentive to lend directly.

These regulatory developments created an incentive to pursue activities which do not require as much capital, since their marginal cost is lower and potential return is higher. Consequently, banks have placed less emphasis on lending and more on purchasing short-term and long-term financial securities and generating non-interest income from off-balance sheet activities. For instance, research by the Bank of England found that during the 1980s, interest income accounted for more than two-thirds of total income for large international banks. In contemporary times, non-interest income tends to be greater than interest income. Figure 1 illustrates the declining proportion of total assets represented by commercial and consumer loans for all regulated US banks. (Click here for a PowerPoint.)

With banks originating less lending, activity has migrated to different avenues in the shadow-banking sector. This sector has always existed, but deregulation and financial innovation created opportunities for the growth of shadow banking – lending which is not financed with deposits. Traditionally, non-bank financial intermediaries (NBFIs), such as pension funds, hedge funds and insurance companies, use funds from investors to buy securities through financial markets. However, new types of NBFIs have emerged which originate loans themselves, notably private credit institutions. As Figure 2 illustrates, a lot of the expansion in the activities of NBFIs has been the due to increased lending by these institutions (defined as ‘other financial institutions (OFIs)). Note that the NBFI line includes OFIs. (Click here for a PowerPoint.)

Since, NBFIs operate outside conventional regulatory frameworks, their credit intermediation and maturity transformation are not subject to the same capital requirements or oversight that banks are. As a result, they do not need to have the same level of capital to insulate against loan losses. Therefore, lending in the shadow-banking sector has a lower marginal cost compared to equivalent lending in the banking sector. Consequently, it generates a higher rate of return. This can explain the large growth in the assets of OFIs illustrated in Figure 2.

Risks in shadow banking

Banking involves trade-offs and this is the case whether the activities happen in the regulated or shadow-banking sector. Increasing lending increases profitability. But as lending continues to increase, at some point the risk-return profile becomes less favourable since institutions are lending to increasingly higher-risk borrowers and for higher-risk projects.

In downturns, when rates of defaults rise, such risks become apparent. Borrowers fail and default, causing significant loan losses for lenders. With lower levels of capital, NBFIs will have a lower buffer to insulate investors from these losses, increasing the likelihood of default.

Is this a problem? Well, for a long-time regulators thought not. It was thought that failures in the shadow-banking sector would have no implications for deposit-holders in regulated banks and the payments mechanism. Unfortunately, current developments in the USA have highlighted that this is unlikely to be the case.

The connections between regulated and shadow banking

The financial system is highly interconnected, and each successive financial crisis has shown that systemic risks lurk in obscure places. On the face of it, NBFIs appear separate from regulated banks. But banks’ new business models have not removed them from the lending channel, merely changed their role. Short-term financing used to be conducted and funded by banks. Now, it is conducted by NBFIs, but still financed by banks. Long-term loan financing is no longer on banks’ balance sheets. However, while the lending is conducted by NBFIs, it is largely funded by banks.

NBFIs cannot be repositories of liquidity. Since they do not have deposits and are not part of the payments system, they have no access to official liquidity backstops. So, they do so indirectly by using deposit-taking banks as liquidity insurance. Banks provide this liquidity in a variety of ways:

  • Investing in the securities issued by private capital funds;
  • Providing bridge financing to credit managers to securitise credit card receivables;
  • Providing prime broker financing to a hedge fund engaged in proprietary trading.

Furthermore, banks have increasingly made loans to NBFIs. Data for US commercial banks lending to the shadow-banking sector are publicly available only since 2015. But, as Figure 3 illustrates, it has seen a steady upward trend with a surge in activity in 2025. (Click here for a PowerPoint.)

Banks had an incentive to diversify into these activities since they are a source of revenue requiring less regulatory capital. The model requires risk and return to follow capital out of the banking system into the shadow-banking sector. However, while risky capital and its associated expected return have moved in the shadow-banking system, not all of the liquidity and credit default risk may have done so. Ultimately, some of that risk may be borne by the deposit-holders of the banks.

This is not an issue if banks are fully aware of the risks. However, problems arise when banks do not know the full risks they are taking.

There are reasons why this may be the case. Credit markets involve significant asymmetric information between lenders and borrowers. This creates conditions for the classic problems of moral hazard and adverse selection.

Moral hazard is a hidden action problem, whereby borrowers take greater risks because they share the possible downside losses with the lender. Adverse selection is the hidden information problem, whereby lenders do not have full information about the riskiness of borrowers or their activities.

The economics of information suggests that banks exploit scale, scope and learning economies to overcome the costs associated with asymmetric information in lending. However, that applies to direct lending when banks have full information about credit default risk on their loan book. When banks finance lending indirectly through NBFIs, there is an extension of the intermediation chain, and while banks may know the NBFIs, they will have much less information about the risks associated with the lending they are ‘underwriting’. This heightens their problems of asymmetric information associated with credit default risk.

What are the risks at present?

The level of debt in the global economy is at unprecedented levels. Data from the International Monetary Fund (IMF) show that it rose to $351 trillion dollars in 2024, approximately 235% of weighted global gross domestic product (GDP). It is in this environment that private credit channels through NBFIs have been expanding. With this, it is more likely that NBFIs’ trade-off between credit risk and return has tilted greatly in favour of the former. Some point to the recent collapse of Tricolor and First Brands – both intermediary financing companies funded by private credit – as evidence of elevated levels of risk.

Many are pointing out that the failures observed in the USA so far have a whiff of fraud associated with them, with suggestions of multiple loans being secured against the same working capital. However, such behaviour is symptomatic of ‘late-cycle’ lending, where the incentive to squeeze more profit from lending in a more competitive environment leads to short-cuts – short-cuts that banks, at one stage removed along the intermediation chain, will have less information about.

It is in a downturn that such risks become apparent. Widening credit spreads and the reduced availability of credit causes financial stress for higher-risk borrowers. Inevitably, that higher risk will lead to higher defaults, more provision for loan losses and write-downs in the value of loan assets.

While investors in NBFIs are first in line to bear the losses, they are not the only ones exposed. At moments of stress, the credit lines that banks have provided get drawn and that increases the exposure of banks to the risks associated with NBFIs and whoever they have lent to. As NBFIs fail, the financing provided by banks will not be repaid and they will thus have to absorb losses associated with the lending of the NBFIs. So, while it appears that risk has left the banking system, it hasn’t. Ultimately, the liquidity and credit default risk of the non-bank sector is financed by bank deposits.

Furthermore, the opaqueness of the exposure of banks to risks in the shadow-banking sector may have issues for the wider financial system. In 2008, banks became wary of lending to each other during the financial crisis because they didn’t know the exposure of counterparty institutions to losses from securitised debt instruments. Now, as more and more banks reveal exposures to NBFIs, concerns about the unknown position of other banks may produce a repeat of the credit crunch which occurred then. A seizing up of credit markets will worsen any downturn. However, unlike 2008, the financial resources available to central banks and governments to deal with any consequences are severely limited.

Only time and the path of the US economy will reveal the extent of any contagion related to lending in the shadow-banking sector. However, central banks are already worried about the risks associated with the shadow-banking sector and have been taking steps to identify and ameliorate them. Events in the USA over the past few weeks may accelerate the process and bring more of that lending within the regulatory cordon.

Articles

Academic paper

Data

Questions

  1. Explain why the need to hold more capital raises its cost for banks.
  2. Why does this reduce the lending they undertake?
  3. What is the attraction of ‘off-balance sheet transactions’ for regulated banks?
  4. Analyse the asymmetric information that banks face when providing liquidity to non-bank financial institutions (NBFIs).
  5. Examine the dangers for the financial system associated with regulated banks’ exposure to NBFIs?
  6. Discuss some policy recommendations regarding bank lending to NBFIs.
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Gold: why the world’s oldest safe haven is back in the spotlight

The gold market has become one of the most talked-about commodity markets in 2025, with prices reaching record highs. This is largely due to increased demand from investors, who see gold as a ‘safe haven’ during times of economic and political uncertainty. Central banks are also buying more gold as a way to reduce their reliance on currencies like the US dollar. With many analysts predicting prices could reach over $4000 per ounce in the next year, the gold market is showcasing how supply and demand, confidence, and global events can all influence a commodity market.

The commodities market is where basic agricultural products, raw materials and metals, such as gold, are bought and sold, often in large quantities and across global exchanges. Commodities are typically traded either in their physical form (like gold bars) at current market prices (spot prices) or through financial contracts, where investors buy or sell in futures markets. These are where a price is agreed today to buy or sell on a specific future date.

As with other commodities, the price of gold is determined by supply and demand. Demand for gold typically rises during times of economic uncertainty as investors want a safer store of value. This results in an increase in its price. Supply and demand, and hence price, also respond to other factors, including interest rates, currency movements, economic growth and growth prospects, and geopolitical events.

Record high prices

This year, the gold market has seen a remarkable rally, with the price of gold hitting a record high. Demand for the precious metal has resulted in spot prices surging over 35% to date (see the chart: click here for a PowerPoint). Rising prices earlier this year have been attributed to the US President, Donald Trump, announcing wide-ranging tariffs which have upset global trade. On 2 September, the spot gold price hit $3508.50 per ounce, continuing its upwards trend.

The price has also been lifted by expectations that the Federal Reserve (the US central bank) will cut its key interest rate, making gold an even more attractive prospect for investors. If the Federal Reserve cuts interest rates, the price of gold usually increases. This is because gold does not pay any interest or yield, so when interest rates are high, investors can earn better returns from alternatives, such as savings accounts or bonds. However, when interest rates fall, those returns become less attractive, making gold relatively more appealing.

Lower interest rates also tend to weaken the US dollar, which makes gold cheaper for foreign buyers, increasing global demand. Since gold is priced in dollars, a weaker dollar usually leads to higher gold prices.

Additionally, interest rate cuts are often a response to economic problems or uncertainty. As gold is viewed as a safer asset for investors during times of economic uncertainty, investors will typically increase their demand.

Unlike the market for currencies or shares, gold doesn’t rely on the performance of a government or company. This makes it attractive when people are worried about things like inflation, recession, war or stock market crashes. Gold is thus seen as a ‘safe haven’.

Gold and the Federal Reserve

The rise in the price of gold by more than a third this year can be linked to the US election last year, according to the director of research at BullionVault (see the BBC article below). Attitudes of the Trump administration towards the Federal Reserve have created concerns among investors. Fears that the US administration could erode the independence of the world’s most important central bank have fuelled the latest flows into the metal, which is traditionally viewed as a hedge against inflation.

According to the BBC article, Derren Nathan from Hargreaves Lansdown claims that it is Trump’s ‘attempts to undermine the independence of the Federal Reserve Bank’ that were ‘driving renewed interest in safe haven assets, including gold’. Investors are concerned that a politicised Fed would be more inclined to cut interest rates than would otherwise be the case, sending long-term inflation expectations higher.

This could lead to fears that future interest rates would then be pushed higher. This would increase the yields on longer-term government bonds by pushing down their price, as investors demand higher compensation for the increased risk of higher future interest rates reducing the value of their fixed-rate investments. This would force the US Treasury to pay higher interest on new bonds, making it more expensive to service US government debt.

Expected price rises for 2026

As we saw above, it is predicted that the price of gold will rise to $4000 per ounce next year. However, if the market sees investors move away from dollar assets, such as US Treasuries, the price increases would be even higher. Daan Struyven, co-head of global commodities research at Goldman Sachs explains ‘If 1 per cent of the privately owned US Treasury market were to flow to gold, the gold price would rise to nearly $5000 per troy ounce’ (see Financial Times article below).

If the Federal Reserve does come under political pressure, it could affect the stability of the US economy and beyond. When gold prices rise sharply, demand usually falls in countries like China and India, which are the world’s largest buyers of gold jewellery. However, in 2025, this trend has changed. Instead of reducing their gold purchases, people in these countries have started buying investment gold, such as bars and coins, showing a shift in consumer behaviour from jewellery to investment assets.

At the same time, global events are also influencing the gold market. Suki Cooper, a metals analyst at Standard Chartered, said that events like Russia’s invasion of Ukraine have added to political uncertainty, which tends to increase demand for gold as a safe-haven asset. She also highlighted how changes in international trade policies have disrupted supply chains and contributed to higher inflation, both of which have made gold more attractive to investors. Additionally, a weaker US dollar earlier in the year made gold cheaper for buyers using other currencies, which boosted global demand even further.

Conclusion

Although the gold market is expected to remain strong over the next six months, some uncertainty remains. Many analysts predict that gold prices will stay high or even increase further, especially if interest rates in the US are cut as expected. Continued global instability, is also likely to keep demand for gold as a safe haven high. At the same time, if inflation stays elevated or trade disruptions continue, more investors may turn to gold to protect their wealth.

However, if economic conditions stabilise or interest rates rise again, gold demand could fall slightly, leading to a potential dip in prices. Overall, the outlook for gold remains positive, but sensitive to changes in global economic and political events.

Articles

Data

Questions

  1. What factors influence the price of a commodity such as gold on the global market?
  2. Use a demand and supply diagram to illustrate what has been happening to the gold price in recent months.
  3. Find out what has been happening to silver prices. Are the explanations for the price changes the same as for gold?
  4. Why might investors choose to buy gold during times of economic or political uncertainty?
  5. How will changes in interest rates affect both the demand for and the price of gold?
  6. What are the possible consequences of rising gold prices for countries like India and China, where there is a traditionally high demand for gold jewellery?
  7. How do global events impact commodity markets? Use gold as an example in your answer.
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Low UK business investment: the problem of high minimum expected rates of return

The UK’s poor record on productivity since the 2008 financial crisis is well documented, not least in this blog series. Output per worker has flatlined over the 17 years since the crisis. As was noted in the blog, The UK’s poor productivity record, low UK productivity is caused by a number of factors, including the lack of investment in training, the poor motivation of many workers and the feeling of being overworked, short-termism among politicians and management, and generally poor management practices.

One of the most significant issues identified by analysts and commentators is the lack of investment in physical capital, both by private companies and by the government in infrastructure. Gross fixed capital formation (a measure of investment) has been much lower in the UK compared to international competitors.

From Figure 1 it can be observed that, since the mid-1990s, the UK has consistently had lower investment as a percentage of GDP compared to other significant developed market economies. The cumulative effect of this gap has contributed to lower productivity and lower economic growth.

Interestingly, since the financial crisis, UK firms have had high profitability and associated high cash holdings. This suggests that firms have had a lot of financial resources to reinvest. However, data from the OECD suggests that reinvestment rates in the UK, typically 40–50% of profit, are much lower than in many other OECD countries. In the USA the rate is 50%, in Germany 60–70% and in Japan 70%+. There is much greater emphasis in the UK on returning funds to shareholders through dividends and share buybacks. However, the reinvestment of much of this cash within firms could have gone some way to addressing the UK’s investment gap – but, it hasn’t been done.

Analysis by the OECD suggest that, while the cost of financing investment has declined since the financial crisis, the gap between this and the hurdle rate used to appraise investments has widened. Between 2010 and 2021 the difference nearly doubled to 4%. This increase in the hurdle rate can be related to increases in the expected rate of return by UK companies and their investors.

In this blog we will analyse (re)investment decisions by firms, discussing how increases in the expected rate of return in the UK raise the hurdle rate used to appraise investments. This reduces the incentive to engage in long-term investment. We also discuss policy prescriptions to improve reinvestment rates in the UK.

Investment and the expected rate of return

Investment involves the commitment of funds today to reap rewards in the future. This includes spending on tangible and intangible resources to improve the productive capacity of firms. Firms must decide whether the commitment of funds is worthwhile. To do so, economic theory suggests that they need to consider the compensation required by their provider of finance – namely, investors.

What rewards do investors require to keep their funds invested with the firm?

When conducting investment appraisal, firms compare the estimated rate of return from an investment with the minimum return investors are prepared to receive (termed the ‘expected return’). Normally this is expressed as a percentage of the initial outlay. Firms have to offer returns to investors which are equal to or greater than the minimum expected return – the return that is sufficient to keep funds invested in the firm. Therefore, returns above this minimum expected level are termed ‘excess returns’.

When firms conduct appraisals of potential investments, be it in tangible or intangible capital, they need to take into account the fact that net benefits, expressed as cash flows, will accrue over the life of the investment, not all at once. To do this, they use discounted cash flow (DCF) analysis. This converts future values of the net benefits to their present value. This is expressed as follows:

Where:
NPV = Net present value (discounted net cash flows);
K = Capital outlay (incurred at the present time);
C = Net cash flows (occur through the life of the investment project);
r = Minimum expected rate of return.

In this scenario, the investment involves an initial cash outlay (K), followed in subsequent periods by net cash inflows each period over the life of the investment, which in this case is 25 years. All the cash flows are discounted back to the present so that they can be compared at the same point in time.

The discount rate (r) used in appraisals to determine the present value of net cash flows is determined by the minimum expected return demanded by investors. If at that hurdle rate there are positive net cash flows (+NPV), the investment is worthwhile and should be pursued. Conversely, if at that hurdle rate there are negative net cash flows (–NPV), the investment is not worthwhile and should not be pursued.

According to economic theory, if a firm cannot find any investment projects that produce a positive NPV, and therefore satisfy the minimum expected return, it should return funds to shareholders through dividends or share buybacks so that they can invest the finance more productively.

Firm-level data from the OECD suggest that UK firms have had higher profits and this has been associated with increased cash holdings. But, due to the higher hurdle rate, less investment is perceived to be viable and thus firms distribute more of their profits through dividends and share buybacks. These payouts represent lost potential investment and cumulatively produce a significant dent in the potential output of the UK economy.

Why are expected rates of return higher in the UK?

This higher minimum rate of expected return can be explained by factors influencing its determinants; opportunity cost and risk/uncertainty.

Higher opportunity cost.  Opportunity cost relates to the rate of return offered by alternatives. Investors and, by implication firms, will have to consider the rate of return offered by alternative investment opportunities. Typically, investors have focused on interest rates as a measure of opportunity cost. Higher interest rates raise the opportunity cost of an investment and increase the minimum expected rate of return (and vice versa with lower interest rates).

However, it is not interest rates that have increased the opportunity cost, and hence the minimum expected rate of return associated with investment, in the UK since the financial crisis. For most of the period since 2008, interest rates have been extremely low, sitting at below 1%, only rising significantly during the post-pandemic inflationary surge in 2022. This indicates that this source of opportunity cost for the commitment of business investment has been extremely low.

However, there may be alternative sources of opportunity cost which are pushing up the expected rate of return. UK investors are not restricted to investing in the UK and can move their funds between international markets determined by the rate of return offered. The following table illustrates the returns (in terms of percentage stock market index gain) from investing in a sample of UK, US, French and German stock markets between August 2010 and August 2025.

When expressed in sterling, returns offered by UK-listed companies are lower across the whole period and in most of the five-yearly sub-periods. Indeed, the annual equivalent rate of return (AER) for the FTSE 100 index across the whole period is less than half that of the S&P 500. The index offered a paltry annual return of 2.57% between 2015 and 2020, while the US index offered a return of 16.48%. Both the French and German indices offered higher rates of return, in the latter part of the period particularly. This represents a higher opportunity cost for UK investors and may have increased their expectations about the return they require for UK investments.

Greater perceived risk/uncertainty.  Expected rates of return are also determined by perceptions of risk and uncertainty – the compensation investors need to bear the perceived risk associated with an investment. Investors are risk averse. They demand higher expected return as compensation for higher perceived risk. Higher levels of risk aversion increase the expected rate of return and related investment hurdle rates.

There has been much discussion of increased uncertainty and risk aversion among global investors and firms (see the blogs Rising global uncertainty and its effects, World Uncertainty Index, The Chancellor’s fiscal dilemma and Investment set to fall as business is baffled by Trump). The COVID-19 pandemic, inflation shocks, the war in Ukraine, events across the Middle East and the trade policies adopted by the USA in 2025 have combined to produce a very uncertain business environment.

While these have been relatively recent factors influencing world-wide business uncertainty, perceptions of risk and uncertainty concerning the UK economy seem to be longer established. To measure policy-related economic uncertainty in the UK, Baker, Bloom and Davis at www.PolicyUncertainty.com construct an index based on the content analysis of newspaper articles mentioning terms reflecting policy uncertainty.

Figure 2 illustrates the monthly index from 1998 to July 2025. The series is normalised to standard deviation 1 prior to 2011 and then summed across papers, by month. Then, the series is normalised to mean 100 prior to 2011.

Some of the notable spikes in uncertainty in the UK since 2008 have been labelled. Beginning with the global financial crisis, investors and firms became much more uncertain. This was exacerbated by a series of economic shocks that hit the economy, one of which, the narrow vote to leave the European Union in 2016, was specific to the UK. This led to political turmoil and protracted negotiations over the terms of the trade deal after the UK left. This uncertainty has been exacerbated recently by the series of global shocks highlighted above and also the budget uncertainty of Liz Truss’s short-lived premiership and now the growing pressure to reduce government borrowing.

While spikes in uncertainty occurred before the financial crises, the average level of uncertainty, as measured by the index, has been much higher since the crisis. From 1998 to 2008, the average value was 89. Since 2008, the average value has been 163. Since the Brexit vote, the average value has been 185. This indicates a much higher perception of risk and uncertainty over the past 15 year and this translates into higher minimum expected return as compensation. Consequently, this makes many long-term investment projects less viable because of higher hurdle rates. This produces less productive investment in capital, contributing significantly to lower productivity.

Policy proposals

There has been much debate in the UK about promoting greater long-term investment. Reforms have been proposed to improve public participation in long-term investment through the stock market. To boost investment, this would require the investing public to be prepared to accept lower expected returns for a given level of risk or accept higher risk for a given level of returns.

Evidence suggests that the appetite for this may be very low. UK savers tend to favour less risky and more liquid cash deposits. It may be difficult to encourage them to accept higher levels of risk. In any case, even if they did, many may invest outside the UK where the risk-return trade-off is more favourable.

Over the past 10 years, policy uncertainty has played a significant role in deterring investment. So, if there is greater continuity, this may then promote higher levels of investment.

The Labour government has proposed policies which aim to share or reduce the risk/uncertainty around long-term investment for UK businesses. For instance, a National Wealth Fund (NWF) has been established to finance strategic investment in areas such as clean energy, gigafactories and carbon capture. Unfortunately, the Fund is financed by borrowing through financial markets and the amount expected to be committed over the life of the current Parliament is only £29 billion, assuming that private capital matches public commitments in the ratio expected. It is questionable whether the Fund’s commitment will be sufficient to attract private capital.

Alternatively, Invest 2035 is a proposal to create a stable, long-term policy environment for business investment. It aims to establish an Industrial Strategy Council for policy continuity and to tackle issues like improving infrastructure, reducing energy costs and addressing skills gaps. Unfortunately, even if there is some attempt at domestic policy stability, the benefits may be more than offset by perceptions around global uncertainty, which may mean that UK investors’ minimum expected rates of return remain high and long-term investment low for the foreseeable future.

Articles

Data

Questions

  1. Use the marginal efficiency of capital framework to illustrate the ‘lost’ investment spending in the UK due to the investment hurdle rate being higher than the cost of capital.
  2. Explain the arbitrage process which produces the differences in valuations of UK securities and foreign ones due to differences in the expected rate of return.
  3. Sketch an indifference curve for a risk-averse investor, treating expected return and risk as two characteristics of a financial instrument.
  4. How does higher uncertainty affect the slope of an indifference curve for such an investor? How does this affect their investment hurdle rate?
  5. Analyse the extent to which the proposed polices can reduce the investment hurdle rate for UK companies and encourage greater levels of investment.
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Rising global uncertainty and its effects

In a blog in October 2024, we looked at global uncertainty and how it can be captured in a World Uncertainty Index. The blog stated that ‘We continue to live through incredibly turbulent times. In the past decade or so we have experienced a global financial crisis, a global health emergency, seen the UK’s departure from the European Union, and witnessed increasing levels of geopolitical tension and conflict’.

Since then, Donald Trump has been elected for a second term and has introduced sweeping tariffs. What is more, the tariffs announced on so-called ‘Liberation Day‘ have not remained fixed, but have fluctuated with negotiations and threatened retaliation. The resulting uncertainty makes it very hard for businesses to plan and many have been unwilling to commit to investment decisions. The uncertainty has been compounded by geopolitical events, such as the continuing war in Ukraine, the war in Gaza and the June 13 Israeli attack on Iran.

The World Uncertainty Index (WUI) tracks uncertainty around the world by applying a form of text mining known as ‘term frequency’ to the country reports produced by the Economist Intelligence Unit (EIU). The words searched for are ‘uncertain’, ‘uncertainty’ and ‘uncertainties’ and the number of times they occur as percentage of the total words is recorded. To produce the WUI this figure is then multiplied by 1m. A higher WUI number indicates a greater level of uncertainty.

The monthly global average WUI is shown in Chart 1 (click here for a PowerPoint). It is based on 71 countries. Since 2008 the WUI has averaged a little over 23 000: i.e. 2.3 per cent of the text in EIU reports contains the word ‘uncertainty’ or a close variant. In May 2025, it was almost 79 000 – the highest since the index was first complied in 2008. The previous highest was in March 2020, at the start of the COVID-19 outbreak, when the index rose to just over 56 000.

The second chart shows the World Trade Uncertainty Index (WTUI), published on the same site as the WUI (click here for a PowerPoint). The method adopted in its construction therefore mirrors that for the WUI but counts the number of times in EIU country reports ‘uncertainty’ is mentioned within proximity to a word related to trade, such as ‘protectionism’, ‘NAFTA’, ‘tariff’, ‘trade’, ‘UNCTAD’ or ‘WTO.’

The chart shows that in May 2025, the WTUI had risen to just over 23 000 – the second highest since December 2019, when President Trump imposed a new round of tariffs on Chinese imports and announced that he would restore steel tariffs on Brazil and Argentina. Since 2008, the WTUI has averaged just 2228.

It remains to be seen whether more stability in trade relations and geopolitics will allow WUI and WUTI to decline once more, or whether greater instability will simply lead to greater uncertainty, with damaging consequences for investment and also for consumption and employment.

Articles

Uncertainty Indices

Questions

  1. Explain what is meant by ‘text mining’. What are its strengths and weaknesses in assessing business, consumer and trade uncertainty?
  2. Explain how the UK Monthly EPU Index is derived.
  3. Why has uncertainty increased so dramatically since the start of 2025?
  4. Compare indices based on text mining with confidence indices.
  5. Plot consumer and business/industry confidence indicators for the past 24 months, using EC data. Do they correspond with the WUI?
  6. How may uncertainty affect consumers’ decisions?
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Investment set to fall as business is baffled by Trump

Economic growth is closely linked to investment. In the short term, there is a demand-side effect: higher investment, by increasing aggregate demand, creates a multiplier effect. GDP rises and unemployment falls. Over the longer term, higher net investment causes a supply-side effect: industrial capacity and potential output rise. This will be from both the greater quantity of capital and, if new investment incorporates superior technology, from a greater productivity of capital.

One of the biggest determinants of investment is certainty about the future: certainty allows businesses to plan investment. Uncertainty, by contrast, is likely to dampen investment. Investment is for future output and if the future is unknown, why undertake costly investment? After all, the cost of investment is generally recouped over several months or year, not immediately. Uncertainty thus increases the risks of investment.

There is currently great uncertainty in the USA and its trading partners. The frequent changes in policy by President Trump are causing a fall in confidence and consequently a fall in investment. The past few weeks have seen large cuts in US government expenditure as his administration seeks to dismantle the current structure of government. The businesses supplying federal agencies thus face great uncertainty about future contracts. Laid-off workers will be forced to cut their spending, which will have knock-on effect on business, who will cut employment and investment as the multiplier and accelerator work through.

There are also worries that the economic chaos caused by President Trump’s frequent policy changes will cause inflation to rise. Higher inflation will prompt the Federal Reserve to raise interest rates. This, in turn, will increase the cost of borrowing for investment.

Tariff uncertainty

Perhaps the biggest uncertainty for business concerns the imposition of tariffs. Many US businesses rely on imports of raw materials, components, equipment, etc. Imposing tariffs on imports raises business costs. But this will vary from firm to firm, depending on the proportion of their inputs that are imported. And even when the inputs are from other US companies, those companies may rely on imports and thus be forced to raise prices to their customers. And if, in retaliation, other countries impose tariffs on US goods, this will affect US exporters and discourage them from investing.

For many multinational companies, whether based in the USA or elsewhere, supply chains involve many countries. New tariffs will force them to rethink which suppliers to use and where to locate production. The resulting uncertainty can cause them to delay or cancel investments.

Uncertainty has also been caused by the frequent changes in the planned level of tariffs. With the Trump administration using tariffs as a threat to get trading partners to change policy, the threatened tariff rates have varied depending on how trading partners have responded. There has also been uncertainty on just how the tariff policy will be implemented, making it more difficult for businesses to estimate the effect on them.

Then there are serious issues for the longer term. Other countries will be less willing to sign trade deals with the USA if they will not be honoured. Countries may increasingly look to diverting trade from the USA to other countries.

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Questions

  1. Find out what tariffs have been proposed, imposed and changed since Donald Trump came to office on 20 January 2025.
  2. In what scenario might US investment be stimulated by Donald Trump’s policies?
  3. What countries’ economies have gained or are set to gain from Donald Trump’s policies?
  4. What is the USMCA agreement? Do Donald Trump’s policies break this agreement?
  5. Find out and explain what has happened to the US stock market since January 2025. How do share prices affect business investment?
  6. Which sector’s shares have risen and which have fallen?
  7. Using the Data link above, find out what has been happening to the US Policy Uncertainty Index since Donald Trump was elected and explain particular spikes in the index. Is this mirrored in the global Policy Uncertainty Index?
  8. Are changes in the Policy Uncertainty Index mirrored in the World Uncertainty Index (WUI) and the CBOE Volatility Index: VIX?