Outlook Overview: Turbulent Times

·        The U.S. slowdown remains in focus as the lagged effects of President Trump’s tariff increases continues to feedthrough, though our baseline is for a 2026 soft-landing.  The Supreme court will likely rule against part of Trump’s reciprocal tariffs, which will create short-term uncertainty.  However, Trump will likely increase other tariffs, but also codify tariffs in the trade framework deals that have been struck in 2025.  Some H1 2026 softness of the U.S. economy remains our baseline and a temporary increase in inflation.  The Fed will likely pause in early 2026, but then resume down to a 3.00-3.25% Fed Funds rate (here).  While Trump appointees will increase at the Fed, they are unlikely to dominate voting or actual policy rate levels but could led to internal Fed disagreements and communication problems (here). Our new 2027 forecasts are for a Fed on hold, as it waits for economic recovery to broaden.  The Democrats are likely to regain the House and this will mean fiscal deadlock until at least 2029.      

·        Meanwhile, tariffs outside the U.S. are disinflationary, as they hurt exports and employment as China is seeking to redirect excess production at competitive prices. Other DM economies recoveries are also being restrained by population aging, slow productivity and cautious consumers in certain countries. This points to further easing from the ECB and BOE, though fiscal policy is mixed with UK tightening but Germany easing.  Meanwhile, we think further BOJ rate normalization will be slow, as inflation slows.  A sharp spike in JGB yields (QT at 6% of GDP in 2026) could see the BOJ also doing a partial U turn on the pace of QT. In 2027, the French presidential election will attract attention, but is unlikely to lead to an acceleration of fiscal consolidation which could cause increased fiscal tensions. 

·        For China, economic momentum is slowing into 2026 due to a modest consumer, plus continued drag from residential investment and slowing exports pointing to a trend slowdown to 4%. However, further fiscal stimulus is highly likely and suggests 2026 GDP growth of 4.4%.  India should prove resilient, due to domestic stimulation.  Brazil growth will likely slow as the lagged effects of very tight monetary policy feeds through, but we foresee BCB will start easing by spring 2026 with more cuts in 2027. The key October 2026 Brazil presidential election is currently too close to call.  In terms of DM and EM financial stability our review highlights the most serious issue remains the 2nd tier bank problems in China (here).

·        AI will provide a boost to U.S./Asia and China economies, as heavy investment in semiconductors/data centers/enterprise AI is partially funded out of cash flow.  Cost savings via labor shedding has started to appear (here), but for the next 1-2 years is unlikely to be at a faster pace than the ICT revolution (manual jobs are unlikely to be cost effectively replaced until the 2030’s due to battery life problems with humanoid robots). However, fear that AI could replace jobs could impact consumer behavior, and this needs to be monitored in the U.S.  New revenue from AI services are taking off, but may not match exponential expectations due to lags in adoption beyond the early movers. Profit margin questions also exist from expensive cost of AI services and competition from open source AI.  AI will boost productivity in DM and China multi-year.   By 2027, this could see some AI companies that depend on external finance having some volatility in their financing (here) that adversely impacts aggressive expansion plans and the boost to U.S. growth could be less.  AI will also boost productivity in DM and China multi-year.

·        Geopolitically, we do not see China invading or blockading Taiwan in 2026 or 2027, as this is an ultra-high risk strategy with the U.S. maintaining its strategic ambiguity. Our baseline remains for ongoing grey warfare, with a 20% probability of a temporary China coastguard partial quarantine operations in 2027 (here).  Re Ukraine, our baseline (70%) remains for a Russia friendly peace deal in Q4 2026/Q1 2027, with both sides making little military progress – the alternative is for the war to continue (30%).  Removal of sanctions will be slow, while Europe will likely be reluctant to become addicted to cheap Russian gas again.

·        For financial markets, the muddle through for global economics and policy provides support for risk assets, combined with solid earnings prospects from some of the magnificent 7.  However, U.S. equities are once again significantly overvalued and we look for a 5-10% correction in 2026, before a recovery to end-2026 around 7,300 for the S&P500.  Risks are greater in 2027 and we forecast 6,850.  The risk of some AI disappointment is greater in 2027, while rates will have bottomed and the U.S. Treasury market will be debating the risk of Fed tightening into 2028.  DM equity markets ex Japan will find it difficult to outperform, though we think Brazil and India can beat the U.S. in 2026 and 2027.  Meanwhile, we favor 2026 bullish yield curve steepening in U.S./EZ and UK government bond markets, as further rate cuts help short-end yields to move lower.  2027 will then likely see yield curve flattening, as markets wonder whether the next move is to higher rates.  Further USD declines are forecast against DM currencies in 2026 and 2027, though at a slower pace than 2025.

·        Risks to our views: A hard landing in the U.S. economy would spillover globally in GDP terms, but recent data points more to a soft landing and we have reduced the risk of a U.S. recession from 30% to 20% in the next 12 months.  While any mild U.S. recession would likely trigger more aggressive Fed easing, it could still prompt a bear market in U.S. equities and a noticeable decline in the USD. 

Figure 1: Economic Scenarios

Source: Continuum Economics

Market Implications

Figure 2: Asset Allocation for the Next 12 Months

 Source: Continuum Economics Note: Asset views in absolute total returns from levels on December 16 2025 (e.g., 0 = -5 to +5%, +1 = 5-10%, +2 = 10% plus).

·        Government Bonds. Fed, ECB and BOE rate cuts can help short-end yields decline in 2026, which will cause bullish yield curve steepening in U.S./EZ and UK government bond markets in 2026.  Japan can see bearish yield curve steepening, as BOJ QT is very aggressive and likely to produce a spike in 10yr yields towards 2.25-2.50%. 2027 will then likely see yield curve flattening, as markets wonder whether the next move is to higher rates. 

·        Equities.  A soft landing for the U.S. economy, plus 2026 solid earnings for some big Tech companies, can provide support for risk assets.  However, U.S. equities are once again significantly overvalued and we look for a 5-10% correction in 2026, before a rebound to end at 7,300 for the S&P500. Risks are greater in 2027 and we forecast 6,850.   The risk of some AI disappointment is greater in 2027, while rates will have bottomed and the U.S. Treasury market will be debating the risk of Fed tightening into 2028. DM equity markets ex-Japan will find it difficult to outperform, though we think Brazil and India can beat the U.S. in 2026 and 2027.           

·        FX.  Prospects remain for DM currencies to make further moderate gains versus the USD in the next 12-24 months.  Foreign investors are hedging FX for their massive U.S. asset holdings, due to erratic Trump administration policymaking and a still overvalued USD.  JPY can led the way in 2026 and 2027.  EM currencies will be more divergent, with Turkish Lira forecast to fall on stubborn inflation, but the Brazilian Real likely to remain firm versus the USD on very high yield spreads. 

·        Commodities. OPEC is trying to restrain production increases, but demand growth is modest and production is coming on stream outside of OPEC.  This tends to favour a modest price decline in 2026 and we see WTI at and USD53 by end-2026.      

Figure 3: Key Events