Never before have we seen fiscal deficits, or rate cuts of this magnitude, delivered outside of recessions.
With President Trump returning to the White House and trade hostilities back on the agenda, one might have thought markets would be challenged in 2025. Instead, global equities look set to close out the year with yet another double-digit gain.
Markets have understood that while geopolitical hostilities dominate the headlines, other forces are also at play. The bigger story is the ever-increasing monetary and fiscal fuel being delivered to an already healthy economic engine.
Indeed, never before have we seen fiscal deficits, or rate cuts of this magnitude, delivered outside of recessions (see Exhibits 1 and 2).
US citizens will start to feel the personal benefits of fiscal stimulus when the One Big Beautiful Bill results in significant tax rebates early in 2026. This cash flow boost adds to the wealth effects being generated by double-digit stock and house price gains. Under intense political pressure, the Federal Reserve (Fed) now seems likely to bring interest rates back to ‘neutral’ – a level which it believes to be around 3%. It is important to note that not all US citizens are feeling the benefits of fiscal stimulus and lower interest rates, with spending increasingly driven by middle- and higher-income households rather than those on lower incomes. Exhibit 3 depicts why the US has recently been termed the K-shaped economy.
Alongside middle- and higher-income households, businesses are also spending at pace, particularly technology companies. The hundreds of billions of dollars of capex we hear about during US earnings calls are tangibly adding to US growth.
Activity should also meaningfully accelerate in continental Europe in 2026. The enormous fiscal stimulus announced in Germany in 2025 will start to feed through into economic data. This spending covers a very wide range of potential projects, from defence to transport infrastructure and industrial support measures. The investment-focused nature of Germany’s plans should aid manufacturing activity and broader growth.
The rest of Europe is also looking to spend more on defence, having pledged to increase military expenditure to 3.5% of GDP (5% including other associated infrastructure spending) by 2035. In 2024, European Union (EU) defence spending reached €343 billion, up 19% year on year, and by the end of 2027 it is set to hit €400 billion. The EU has announced plans to help member states achieve this, including the €150 billion ‘Security Action for Europe’ (SAFE) programme that provides loans for defence procurement, as well as tweaks to its fiscal rules.
As European Central Bank (ECB) President Lagarde has noted, defence spending can be productivity-enhancing if research and development spills over to innovation. Historically, European defence spending has tilted towards personnel, but future plans look likely to focus on procurement from European-domiciled firms, supporting activity.
Investors shouldn’t underestimate the potency of fiscal policy. In our view, the lack of fiscal stimulus in Europe relative to the US goes a long way towards explaining the growth differential between the two regions over the past 15 years (see Exhibit 4). Fiscal stimulus also helps explain why southern Europe, which received most of the EU’s Recovery Fund, has been performing so well in recent years. The fact that Germany is joining the fiscal party – with growth in government investment forecast to hit 20% year on year in 2026 – is therefore big news.
Europe is also benefiting from monetary stimulus. The ECB was quick to lower interest rates as inflation risks receded. The eurozone is still an economy sensitive to short-term interest rates, and past rate cuts continue to support credit growth in the region – both household and corporate loan growth have marched higher this year. In Germany, increased activity in the housing market is likely to be followed by more spending on furniture and home improvement, which should further support domestic demand.
Trade is also likely to be less of a drag on European growth in 2026. The ‘front-loading’ of European exports ahead of the introduction of US tariffs in spring 2025 led to depressed exports over the remainder of the year but as this effect fades, trade is likely to normalise.
Germany – having been termed the sick man of Europe in recent years – therefore looks set to finally start growing.
The French political situation remains a blight on the European landscape, but tough decisions – and fiscal consolidation – have now largely been postponed until the 2027 presidential election. France is, therefore, unlikely to derail the European recovery in 2026. With France fundamentally ‘too big to fail’, we suspect EU solutions may be found to ease this pressure, such as the SAFE programme to support defence spending using the EU balance sheet.
The outlook looks slightly less perky in the UK, with both monetary and fiscal options more limited. As in France, there are political constraints to restraining government spending, so further tax rises will likely weigh on near-term growth. However, slow activity may finally start to bring down inflation, which would at least allow the Bank of England to ease its foot off the brake.
Asia is also providing monetary and fiscal fuel. The election of a new pro-growth prime minister in Japan with strong views on the need for ongoing loose monetary and fiscal policy has reduced the prospect of meaningfully higher Japanese interest rates, securing the country’s place as the ongoing provider of cheap capital to the world.
China has been trying to combine monetary stimulus with targeted fiscal support, but with little success until recent months. Both corporate and household confidence has been subdued since the Covid pandemic, and the government’s regulatory interventions during its shift towards a ‘common prosperity’ narrative appear to have structurally dented Chinese corporates’ appetite to take risk.
However, China’s outlook appears to be at a turning point. The emergence of the artificial intelligence (AI) company DeepSeek was a reminder to the world of China’s entrepreneurial spirit. The recovery in Chinese growth stocks sparked by DeepSeek’s progress has lifted the overall Chinese market, and alongside a stabilisation in home prices this should help lift consumer sentiment. China’s trade has also not really suffered, despite the headlines, as Chinese goods are either redirected to other markets or rerouted via other regions to US consumers (see Exhibit 5).
Overall, with more and more fuel being added to the economic engine, global activity should regain momentum and broaden out regionally as we move through 2026.
Potential derailments: Inflation
Such unprecedented ‘peacetime’ stimulus is not without risks, however. These risks will be important for investors to monitor to ensure that while they enjoy the ride, they are not blinded by potential issues coming down the track that could derail returns.
History suggests that excessive stimulus can prove problematic if it feeds either rising consumer prices (particularly challenging in the 1970s and early 2020s), or asset bubbles (the 1920s and 1990s).
We have been worried about inflation proving problematic, and remain so over the medium term. At present, however, a sufficiently subdued labour market and moderating pay requests are providing central banks comfort that any further uptick in headline inflation will not become embedded via higher inflation expectations and wage growth.
The risk, therefore, for 2026 is that as activity gains momentum, workers start to feel more confident asking for higher pay and inflation does become a bigger issue. We are mindful that economists generally have a poor track record of forecasting inflation spikes. The magnitude and persistence of the inflation rise that occurred in 2022, which proved so traumatic for both stocks and bonds, was not predicted by consensus forecasts (see Exhibit 6).
If inflation does firm further, Western central banks would surely have to postpone the idea of further rate cuts. Some might argue that political pressures would lead central banks to push on with easing regardless. However, bond markets may then get jittery about the monetary authorities’ commitment to price stability, leading to higher long-run yields.
The Fed will be under particular scrutiny in 2026. A combination of the review of the regional Reserve Bank presidents in February, and the replacement of Jerome Powell as Chairman in May, offers the Trump administration opportunities to exert significant influence over monetary policy. If the administration is successful in removing Governor Cook, and the current Trump appointees play ball, there exists a possibility that it could find itself being able to appoint all 12 Reserve Bank presidents and three out of seven governors including the chair.
This is not our core scenario, but if US central bank independence really comes into question, the asset that might suffer most acutely is the dollar. We remind investors again to think carefully about their currency exposure since, as in 2025, dollar moves have the potential to be a major contributor to final returns.
Potential derailments: Asset bubbles
Excess liquidity does not always show up in consumer prices. Sometimes, it finds its way into asset prices. With equity markets sitting on high valuations and house prices soaring in countries like the US and Germany, this is a risk worth scrutinising.
The trouble is that identifying the point when rational excitement becomes irrational exuberance is hard. Gauging the timing of a turn from euphoria to despair is even harder. For this reason, we have devoted an entire chapter of this outlook to the loftiest part of today’s stock market – see Navigate tech concentration carefully. We continue to be nervous about the high degree of concentration towards tech in equity benchmarks, given questions about the return on investment of the enormous amount of capex these companies are undertaking, as well as the gradual rise in leverage now appearing to support this spending. We have also dedicated a chapter to where we see more compelling risk/reward opportunities outside of the US market – see Diversify selectively across global equities.
Our next chapter addresses private credit and private equity, two markets that have also faced questions recently as the potential recipients of excess liquidity that could lead to problems ahead. We find the narrative here less troubling than recent headlines might suggest – see Don’t be fearful of private markets.
Better destinations may yet be ahead
It is not a given that abundant liquidity will lead to either rampant inflation or an asset price bubble. A benign scenario of further sustainable economic expansion is possible, if all this stimulus serves to expand the supply side of the global economy.
This will be the case if AI and other new technologies enhance the productivity of a wide range of companies. The earnings of the tech giants today could eventually be shared with the global corporate universe. These benefits might also then be shared with a more productive labour force. To complete this happy outlook, finance ministers would also find themselves awash with tax receipts from a thriving corporate and household sector, enabling them to repay their earlier spending.
This outlook is possible. We conclude, therefore, with the guidance to remain on the risk train while fuel is still being added to its engine. But we also suggest that investors remain very mindful of how things could go wrong, and to select their carriage carefully – see Protect against derailment. If inflation causes a derailment, both stocks and bonds will likely struggle. A safer onward journey that mitigates against inflation shocks must include the suite of alternatives that provide genuine inflation protection, in our view. If tech falters, those investing passively in US or global equities will find themselves in the front carriage on impact. Investors should therefore think carefully about how they are allocating to ensure they enjoy the ride but also have sufficient protection should the train derail.