After growing at an above trend pace over the previous two quarters, global economic activity seems to have decelerated in the last quarter of 2025, led by a slowdown in China. Nonetheless the global economy - and particularly the US - remains somewhat more resilient than was expected in the aftermath of President Trump's Liberation Day tariff announcements in early April. Reflecting front loaded fiscal stimulus (government spending) in the US, the roll out of German-led defence and infrastructure spending in Europe and further targeted fiscal and monetary policy easing from the Chinese authorities, we expect a re-acceleration in global growth during 2026.
Inflation and its impact on equity markets
Inflation was lower than expected towards the end of 2025. Many had assumed that the new US tariffs would push prices sharply higher, but this did not happen broadly. Lower‑than‑expected inflation created a relatively comfortable environment for financial markets. Economists sometimes refer to this as “goldilocks” conditions—neither too hot (high inflation) nor too cold (a shrinking economy). This environment helped risk assets’ (such as company shares or ‘equities’) prices rise, with the global equity market returning 3.2% in Sterling terms over the quarter. This background also illustrates that, led by the Trump administration's aggressive interventions, it is now policy which drives economic and financial market outcomes rather than the reverse, which has traditionally been the case.
An important trend in 2025 was the growing influence of government policy on financial markets. Historically, economic conditions shaped what governments did. Now, government decisions—such as interest‑rate policies, tariffs and spending—are driving economic outcomes more visibly. This means that understanding how governments and central banks behave is increasingly important.
The United States: a cooling labour market
The US job market showed signs of cooling. Hiring slowed noticeably, but layoffs did not rise significantly. This pattern has been described as ‘no hire, no fire’, suggesting companies are cautious but not yet cutting large numbers of jobs. One possible influence is the growing use of Artificial Intelligence (AI). If AI increases productivity (i.e., helping companies produce more with fewer workers) it could reduce the need for hiring without necessarily increasing unemployment.
With inflation still slightly above its target but the labour market weakening, the US Federal Reserve decided to cut interest rates gradually. Interest rates influence the cost of borrowing for households, businesses and banks. Lower rates encourage spending and investment. Throughout the quarter, the Federal Reserve reduced its key interest rate by 0.25% at each meeting, reaching a range of 3.50–3.75%.
Different countries, different approaches to interest rates
Central banks worldwide took different approaches at the end of 2025:
- The European Central Bank (ECB) kept interest rates at 2%, with officials comfortable that inflation was close to its target.
- The Bank of England cut its Base Rate by 0.25% to 3.75%. However, with inflation likely to fall substantially in the months ahead and the labour market still weak, our take is that the Bank is in danger of falling behind the curve and we would expect more rate cuts than currently discounted by the market.
- The Bank of Japan continued its slow shift away from ultra-low interest rates, raising the policy rate by another 0.25% to 0.75% at its pre-Christmas policy. Even with that tightening path - and this year’s steep rise on long term Japanese government yields - the yen remained weak into year-end and is close to its cheapest level since the late 1980s.
Signs of stress in financial systems
Although markets looked calm on the surface, some signs of financial stress appeared. Usage of an important US funding facility – the Standing Repo Facility – reached record highs at the end of the year. A repo facility allows banks to borrow money very short‑term by using assets as collateral. A spike in usage suggests banks needed more short‑term cash than usual, often a sign of hidden pressures.
To ease this strain, the Federal Reserve introduced a new policy tool: Reserve Management Purchases. While not described officially as quantitative easing (a policy where central banks buy bonds to support the economy), it operates in a similar way and could help stabilise financial markets in early 2026.
One of the biggest questions is when and by how much the US Federal Reserve will cut interest rates in 2026. If inflation continues to improve and the labour market remains in that “cooling but stable” zone, gradual rate cuts should support both bond and equity markets. However, if inflation picks up again, the Federal Reserve might stop cutting rates earlier than expected.
Because central banks are following different paths – for example, the US cutting rates while Japan raises them – currency movements could become more important. Exchange rate shifts can influence trade and investment flows and can create both opportunities and risks.
Bonds and equity markets
For bonds, the good news is that starting yields mean that bond holders can earn a meaningful portion of their return from income alone (often called “carry”), and although long-dated UK gilts performed well in Q4 it is important to be aware that longer maturities can underperform markedly when inflation expectations, government borrowing needs, or term premiums deteriorate. Elsewhere, corporate bonds (investment-grade and high-yield) can still look attractive when defaults are contained, but will become more fragile if the labour market moves from the current slow hiring environment to one of rising layoffs.
Global equities are expected to perform well in 2026. Several factors support this outlook: broadening earnings growth, easing interest rates, stronger company profits and fewer policy‑related headwinds (obstacles to growth). The United States and Asia are expected to lead global growth, partly because investment in AI continues to drive productivity and profitability. Roughly 30 leading companies account for 44% of the S&P 500’s market value and have driven most returns since late 2022, supported by capital expenditure and research & development spending.
Europe, the UK, Japan and Emerging Markets
Europe is in a stronger position than in recent years. Credit conditions – meaning the availability of lending – are improving, and fiscal (government spending) programmes are beginning to take effect. Company profit growth is expected to match that of the US. Attractive equity valuations leave room for gains, particularly in core markets such as Germany and France. Sectors tied to capital expenditure, construction, and industrial modernisation stand to benefit as German-led fiscal stimulus is progressively rolled out. This €1 trillion of planned spending on defence and infrastructure and more flexible EU deficit rules should support mid-cap companies. In the UK, equities still trade at a steep discount to other developed markets, and their mix – heavy in consumer staples, health, and commodities – offers a hedge against inflation, interest rate volatility, and geopolitical uncertainty.
Japan is undergoing important economic reforms, with a policy focused on government spending and structural reforms. This should boost wages, increase investment and encourage companies to use their capital more efficiently. More Japanese households are moving money into equities, which could add momentum to the market.
Emerging markets should outperform developed markets due to lower interest rates, stronger earnings growth and improved government finances in many markets. Valuations add another tailwind. China should experience a policy-led pickup in activity in the first half of the year; elsewhere, Korea stands to gain from ongoing governance reforms and its strong position in AI. More broadly, many emerging Asian countries should benefit from stronger growth relative to wealthier nations.
This positive outlook – with equity earnings and returns broadening out during 2026 – could come unstuck if the supportive liquidity and interest rate cycles of the last two years come to an unexpected and abrupt end. A sharp and unexpected increase in long term sovereign bond yields would be a key conduit of this adverse development but, all told, we expect supportive policy to stay the course, and we start the year in an optimistic frame of mind.
The value of securities and the income from them can fall as well as rise. Past performance should not be seen as an indicator of future returns. All views expressed are those of the author and should not be considered a recommendation or solicitation to buy or sell any products or securities.
