Financial stability in uncertain times

A personal view from Debapratim De, Deloitte’s Chief Economist in the UK.

Financial stability in uncertain times

When interest rates rose across the developed world, after more than a decade of ultra-loose monetary policy, most economists anticipated increased financial stress. While some notable shocks followed – such as pressure on UK gilts after the mini-Budget in 2022 or the failure of Silicon Valley Bank in 2023 – overall, financial stress has remained surprisingly contained.

This resilience stems from tighter banking regulation, following the Global Financial Crisis, leading to better-capitalised lenders, a shift to fixed-rate mortgages slowing interest rate pass-through to households, and substantial government support in response to shocks, transferring some private sector risk to public balance sheets.

Even so, the apparent disconnect between heightened geopolitical tensions, particularly the war in Iran, and relative calm in financial markets is striking. The IMF’s recent Global Financial Stability Report cautions that the conflict remains highly unpredictable and “circumstantial factors could give way to a prolonged war, triggering stress through channels not yet fully apparent”.

Here are three key areas we are monitoring.

Sovereign bond markets – Government bond yields have risen and debt markets have become more volatile due to increased uncertainty about inflation, fiscal policy, levels of public debt and geopolitics. Simultaneously, central banks are reducing their holdings of sovereign bonds. This increases the market’s exposure to price-sensitive, leveraged investors such as hedge funds, whose active risk management practices amplify shocks and drive greater volatility. This turbulence is reflected in the Bank of America MOVE index, which tracks US Treasury volatility and has shown a sharp increase since 2022.

Higher volatility in sovereign bond markets poses a financial stability risk because government debt yields are the reference rate for corporate and household borrowing. Sharp yield movements can rapidly increase borrowing costs across the economy, tightening financial conditions.

A sell-off could also significantly weaken financial institutions holding government bonds as collateral. Falls in bond prices can lead to valuation losses, margin pressures, and liquidity issues. The UK's 2022 LDI crisis, which required Bank of England intervention to stabilise gilt markets, serves as a stark reminder of this vulnerability.

Given the fiscal outlook for developed economies and elevated geopolitical uncertainty, pressure on sovereign bonds is likely to persist. Increased sensitivity to market sentiment means that policymakers will have less room to respond to future crises and be forced to make difficult choices on public spending and taxation to maintain investor confidence.

The AI boom - Equity valuations for US technology and AI-related firms have surged. The market capitalisation of the "Magnificent Seven" US tech giants (including Nvidia, Apple, and Microsoft) has risen by an astonishing 225% since early 2023, increasing their share of the total quoted US equity market from 16% to 28%. Last week Space X, which includes Elon Musk’s AI business xAI, raised $75bn in a record-breaking IPO, valuing the company at $1.78 trillion.

This market exuberance attracts capital and fuels investment in new technologies, with ‘hyperscalers’ projected to deploy $700 billion on AI infrastructure this year alone. But new technologies also inflate asset prices. A 1998 US study found that three-quarters of major innovations between 1825 and 2000 generated stock market bubbles. Transformative technologies create a mix of opportunity and huge uncertainty, where investors struggle to identify which firms will benefit most and how much profit they will make.

The market reaction to the Chinese AI model DeepSeek's release, which briefly wiped hundreds of billions from US market capitalisation in early 2025, underscores the uncertainty surrounding AI deployment and profitability, and the potential for correction if mega-cap stocks fail to justify current valuations.

However, were such a correction to occur, it is less likely to be a Lehman moment. Unlike the subprime bubble, much of the AI capex boom is funded by corporate cash, not borrowing, limiting wider systemic risk. But higher retail consumer exposure to US equities today suggests a sharp selloff could significantly impact household spending and growth. The IMF estimates a readjustment of the scale of the dot-com-crash could wipe out over $20 trillion in US household wealth, roughly 70% of US GDP. That would dent consumer confidence and likely precipitate a downturn.

This remains a serious risk, with several central bankers raising concerns over the last six months. But predicting the timing of a correction can be next to impossible. Alan Greenspan, then chair of the Federal Reserve, famously warned against 'irrational exuberance' in December 1996, when talking of dot-com valuations. The market corrected more than three years after it.
Private credit - Lending outside traditional banking, known as private credit, has grown more than tenfold since 2009, partly due to post-financial-crisis regulation. This growth offers benefits: financing for firms banks might avoid, flexible lending, and diversification of the financial system.

However, regulators highlight several vulnerabilities. Firstly, these markets remain notoriously opaque. That raises concerns about borrower credit quality, leverage, and broader financial market connections. Secondly, liquidity issues have emerged, evidenced by redemption queues in some high-profile private credit funds. Thirdly, a notable concentration of private credit lending is to software firms, a sector vulnerable to AI disruption.

Default rates are currently low, and direct bank exposure to private credit firms is limited, leading many to argue the sector does not yet pose a systemic risk. But a wider private credit crunch could sharply tighten financing conditions for many corporates.

In the fifties, economist John Kenneth Galbraith published a famous book assessing the conditions that led to the Great Crash of 1929. Euphoria about new innovations drove rampant speculation, with risks seen as too small and diversified. Optimism trumped common sense. In the decades since, financial crises have followed this same pattern.

Despite having withstood a number of recent shocks, the global financial system exhibits many elements of this enduring pattern today. In a world of heightened geopolitical uncertainty, highly indebted governments and sector-specific AI disruption, we should not take its resilience for granted.

ONS data show that the selling price of an average London flat is now around £420,000. Just over three decades ago, these properties sold for £67,000 (144,000 in today's prices). Investing in London property has yielded a significant inflation-adjusted return over this period, with the real price of flats up 191% as of March 2026. However, owners and investors face a different story over a more recent timeframe. London flat prices are down by almost a third in real terms since their peak in July 2017.

Several factors explain this weakness. Over the last decade, policy changes, including the stamp duty surcharge on second homes and changes to the tax deductibility of mortgage interest payments for landlords, have made buy-to-let investment less attractive, resulting in lower demand for London flats. In recent years, flat-ownership costs have also increased - higher interest rates since 2022 have raised mortgage repayments, service charges continue to rise, and new building safety regulations have created additional outlays for some owners.

Wider shocks have compounded the trend. Two energy price spikes in recent years have caused higher inflation that erodes real house prices, while the rise of remote working after the COVID-19 pandemic has likely altered demand for flats in the capital. While London flats have seen the greatest real term decline in prices across all regions and dwelling types in the UK, they are not the only affected group. Many of the factors noted above have also hit demand for flats across the country, with prices down in real terms since 2017.

Houses have fared better, especially in the regions. For example, the price of an average detached house in Wales, which was roughly the same as that for a London flat in 1995, has continued to appreciate in real terms, up nearly 20% since mid-2017.