Executive Summary

1. Who truly bears the cost of the ongoing trade war? Primarily exporters for now, but US consumers will also be hit through higher inflation (up by 0.6pp by mid-2026). While global trade routes have shifted, allowing exporters to mitigate the impact, downside risks remain high as sectorial investigations are ongoing and the trade deal with China is still pending. Export losses could in theory range from -0.3% of GDP (EU) to -1.3% of GDP (Vietnam) compared to a pre-trade war scenario. The cost for the US is estimated at -0.3%. FDI pledges in the US, if realized, would amount to 6% of US GDP by 2026-2028, and look very costly for source countries. Overall, growth in global trade of goods and services is expected to slow down to +0.6% in 2026 from +2% in 2025 in volume terms.

2. Has stagflation transitioned from a looming risk to an undeniable reality? Yes, but it is stagflation light for now. Inflation remains above target in many advanced economies – such as the UK, US and Japan – while growth stays lackluster. This combination marks a mild stagflationary phase by historic standards. For most economies, we expect inflation to gradually return toward the 2% target by 2027. While the UK currently stands out with particularly high inflation, the US is likely to see the most prolonged overshoot. A mix of tariffs, continued fiscal stimulus and immigration-driven labor shortages is keeping the US economy mildly overheated and price pressures elevated.

3. Can central banks untangle their complex dilemmas? Central banks in developed markets are navigating a threefold challenge: weak growth, lingering inflation and rising fiscal deficits that are pushing up long-term yields and intensifying focus on global quantitative tightening (QT). We expect the Fed to deliver just three more rate cuts by mid-2026, reaching a terminal rate of 3.25–3.50%, notably above current market pricing. The ECB is done cutting, while the BoE is likely to ease further, lowering rates to 3.0% by 2027 – below current market pricing – as inflation will decline and the economy needs less monetary restrictiveness. In contrast, the BoJ will move in the opposite direction, continuing to hike toward a 1.0% terminal rate, with core inflation still too high to ignore. QT will continue at the ECB, BoE and BoJ – provided bond markets remain orderly. The Fed, however, is largely done with its balance sheet reduction, taking some pressure off longer-term yields.

4. Is the USD's dominance facing a new era of uncertainty? Yes – but don’t write it off yet. Despite the strong de-dollarization narrative, most of the year-to-date weakness in EUR/USD reflects markets pricing in a more dovish Fed relative to the ECB, driven by signs of economic softness in the US rather than doubts about Fed independence. Long-term inflation expectations remain well anchored and near-term price pressures have eased more than expected. However, around a third of the dollar’s decline can indeed be linked to post–“Liberation Day” de-dollarization, primarily via increased FX hedging rather than outright capital outflows. Crucially, the US continues to attract strong foreign investment. Looking ahead, we expect EUR/USD to remain broadly stable as the mild ongoing de-dollarization is likely to be offset by a more hawkish Fed. However, risks are skewed to a weaker USD: political developments – such as more direct interference in monetary policy or renewed “Mar-a-Lago Accord” proposals – could accelerate de-dollarization beyond our baseline.

5. How far can fiscal dominance propel long-term interest rates? Truss-style moments globally cannot be excluded but central bank “puts” remain in place. Rising net bond supply amid high fiscal deficits have pushed long-term yields higher, with UK 30-year yields, for example, hitting their highest levels since the 1990s. Politics will determine the path in France and the US. But central banks remain key players in the game. The pace of quantitative tightening is adding supply on a scale comparable to fiscal deficits in many markets. If needed, they can slow QT – or even restart QE – to stabilize markets.

6. Will the EU finally ramp up defense spending in 2026-27? The EU's "Rearm Europe Plan" allocates EUR800bn over four years, including EUR150bn for military procurement. However, despite substantial funding, Europe faces hurdles in rapidly boosting military capacities due to production constraints, as defense firms have a record backlog (~ EUR350bn) and do not seem likely to increase their capex (~5%). Additionally, low intra-European cooperation and a focus on domestic procurement may hinder long-term projects like the France-German fighter jet initiative. Europe's attempt to reduce reliance on US military imports will be challenged by geopolitical developments in Ukraine and the US-EU trade deal. Consequently, a moderate spending increase of +10-20% until 2027, reaching a defense spending share of 2.3-2.5% of GDP, seems more realistic. This would translate to an impact of around +0.2pp on European GDP growth by then.

7. How are firms navigating the challenge of persistently high financing costs? Despite lower policy rates, corporate demand for loans remains muted in the Eurozone. In the US, corporate loans are picking up despite tighter credit standards. Firms are navigating the challenge of persistently high financing costs by implementing strategic adjustments such as enhancing operational efficiency, renegotiating supplier contracts and investing in automation to reduce expenses. Many large companies are extending debt maturities, deleveraging or raising capital on bond markets where yields are still benign to minimize interest burdens, while also exploring alternative financing sources like private credit or strategic partnerships due to tight/expensive traditional bank lending. The peak in global business insolvencies is expected only in 2027: we expect an increase of +6% and +4% in 2025 and 2026, respectively, before a limited decrease thereafter.

8. Is a capital market bubble on the horizon? No, but the AI boom looks fully priced in, leaving limited near-term upside. While equity markets, especially in the US, trade at high price-earnings valuations, strong long-term earnings growth – projected at 15% annually, compared with 10% in Europe – keeps price-to-earnings-to-growth ratios (PEG) in check. Still, the rally is narrowly concentrated in a few mega-cap tech firms, making the market highly dependent on the delivery of AI expectations.

9. Which emerging markets are grappling with rising imbalances? EMs overall are still in an expansionary cycle, in part thanks to supportive external demand until now. Asian exporters have gained market shares in the US, with Taiwan, Vietnam, Thailand and Indonesia even retaining spare manufacturing capacity. As the economic outlook turns grimmer, with contained inflation and a lower USD, most EM central banks have accelerated policy rate cuts, and the cycle should slow down by mid-2026. More than half of EMs are also easing fiscal policies. Markets do not seem concerned at this stage, but valuation is a growing concern, and some require close monitoring (e.g. Argentina, Brazil, Egypt, Indonesia). Most of Latam and CEE (and some in Southeast Asia and Africa) would also be vulnerable to a risk-off shift, being net debtors with current account deficits. The Chinese economy will slow into 2026, given likely contracting exports and still soft domestic demand. One of the challenges is to restore private confidence and contain deflationary pressures – further policy support will likely be delivered by Q1 2026.

10. What events could steer us towards a downside scenario? Heightened protectionism, with a 45% probability, may lead to a global trade recession driven by US tariff escalations, negatively affecting growth and inflation, while pressuring developed market interest rates and equities. Meanwhile, a de-dollarization policy shock, with a 35% probability, could push the EURUSD above 1.25. A sovereign debt crisis, with a 20% probability, might arise from high debt levels and interest rates, constraining fiscal policies in France, Italy, the UK and the US. Geopolitical tensions could rise further, with a NATO-Russia conflict, an escalation in the Middle East and open conflict between China and Taiwan as potential risks. As upside risks, we see a Ukraine-Russia ceasefire boosting growth and European industrials, and US exceptionalism driving economic expansion through AI advancements and the success of Trumponomics, which would lead to increased growth and positive impacts on DM equities.