Central bank paths
We believe the labor market holds the key to the pace and scale of Fed easing into 2026, so long as inflation remains anchored. If labor market weakness persists, driven by immigration restrictions, federal layoffs, and labor-saving AI, additional Fed rate cuts may follow, especially if tariff-induced inflation is short-lived. We expect the ECB to maintain its 2% rate, given at-target inflation and German fiscal expansion, though we do not rule out a return to rate cuts if inflation begins to moderate. In the UK, we believe easing inflation, a softening labor market, and fiscal contraction support further easing. Disinflation, Fed cuts, and signs of further dollar weakness could lead to further easing in emerging markets, with country variations. Japan remains on track towards a higher rate regime, in our view, backed by firm inflation, strong GDP growth, and potential fiscal easing. With policy rates becoming less restrictive and no tariff-induced recession, rate hikes in other economies are also possible, signaling a new phase in global monetary policy.
A new trade order
US trade deals with the UK, EU and Japan have provided some stabilization after April’s tariff shock. India and the US appear to be closing in on a trade deal.1 The US and China have made progress on tariffs and rare earth controls following the Trump-Xi meeting in South Korea. However, there is potential for an escalation in tensions. The geopolitical dynamics driving the decoupling of the world’s two largest economies continue to outweigh those that favor tighter integration between them. Beyond specific trade deals, the market has broadly anticipated tariffs causing a one-off shift in prices so far, rather than a sustained threat. Proactive tariff mitigation strategies, including supply chain adjustments and selective price increases, have enabled most companies to protect margins so far. As tariffs settle at lower (but not low) levels than initially seemed likely, we believe they still present downside risk to growth in 2026, especially if greater pass-through of tariff costs to consumer prices becomes evident in the coming months.
Deficits and debt
Pinpointing the exact moment when fiscal anxieties will emerge or peak is impossible, but a deep understanding of the landscape is essential. The US fiscal deficit is unusually large relative to the economy’s strength, with the debt-to-GDP ratio approaching a post-war high and higher real rates steepening the path of interest expenses. Elsewhere, persistent political instability in France has created a fragmented parliament, making meaningful fiscal reform difficult. This has sharpened investor focus on France’s deteriorating fiscal outlook ahead of the 2027 presidential elections, with 10-year French government bond yields now matching those in Italy. Across markets, spending pressures are also mounting. These include higher defense outlays, the climate transition, and rising healthcare and pension costs due to demographic aging.
