Frayed Nerves

Forecasting is always fraught, but geopolitical turmoil makes it especially hazardous. Economic projections are only as reliable as the assumptions behind them, and those inputs can change quickly when conflicts are involved. Our outlook therefore rests on a baseline scenario in which the Middle East conflict will simmer for an extended period but not boil over.

In this event, resilient energy supply chains should help prevent oil prices from spiraling. Inflation is likely to remain elevated but manageable, placing a ceiling on bond yields and keeping most central banks on hold. Fiscal policy is expected to provide partial cushioning for households and businesses. The result is an outlook for resilience rather than strength: growth should continue, but activity in most economies is likely to remain modest at best.

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Following are our outlooks for the world’s major markets.

United States

Consumption has proven surprisingly resilient despite higher gasoline prices. June retail sales continued to grow; core retail sales posted their strongest quarterly gain in four years during the second quarter, suggesting households remain willing to spend. Consumers appear to be absorbing higher costs by drawing down savings, with the saving rate falling to a four-year low. Tech sector gains continue to generate wealth effects, supporting spending.
Inflation remains the key risk to the outlook. June's consumer price index report provided some temporary relief. Both headline and core inflation moved lower, with little evidence that higher energy costs have yet fed through to broader prices. However, the recent rebound in oil prices could make that respite short-lived. Tariffs are back, and the AI buildout is adding to inflation. With a firm labor market, the Federal Reserve has signaled a willingness to tighten further should price pressures persist. Our base case remains for rates to stay unchanged through 2027, though the balance of risks is shifting more towards hikes than cuts. Our latest U.S. outlook can be found here.

Canada

After contracting in each of the previous two quarters, the Canadian economy likely returned to growth in the second quarter. Real gross domestic product (GDP) rose in both April and May, suggesting that activity regained some momentum at the start of the quarter. Labor market conditions have also shown signs of stabilization, though the underlying picture remains mixed. Meanwhile, core inflation remains contained, allowing the Bank of Canada to leave its policy rate unchanged. Policymakers are expected to look through the recent energy-price shock amid soft domestic demand.
Looking ahead, Canada faces a challenging series of headwinds that are likely to keep growth subdued and vulnerable to downside surprises. A shrinking population and elevated trade policy uncertainty will continue to weigh on activity. Uncertainty surrounding the United States-Mexico-Canada Agreement (USMCA) has also intensified, with the pact now subject to joint annual reviews that could discourage long-term investment decisions. The U.S. administration has announced new 50% tariffs on several Canadian goods covered under the USMCA. Canada's efforts to broaden commercial ties with China as part of its trade diversification strategy risk creating additional friction with Washington, further complicating the outlook.

Eurozone

The eurozone economy appears to have ended the first half of the year on firmer footing than previously anticipated. Incoming data point to stronger activity, supported by resilient consumer spending, improving industrial conditions, and a labor market that remains relatively tight. However, the outlook has become more uncertain as renewed hostilities in the Middle East are reigniting price pressures. Political developments could add to fiscal concerns across the eurozone. A stronger showing by the right wing in France's 2027 presidential election, alongside growing pressure to shield households and businesses from higher energy costs, could lead to fiscal slippage in some member states.
The European Central Bank (ECB) left rates unchanged in July, consistent with benign inflation readings and limited evidence that higher energy costs have generated broader second-round price pressures. However, the recent surge in oil and gas prices has complicated the inflation outlook, strengthening the case for additional policy tightening. With price pressures ascending, we expect the ECB to deliver another rate hike in September.

United Kingdom

The U.K. economy showed some renewed momentum in the second quarter, but we remain cautious about the broader growth outlook. As in recent years, it appears that a strong start to the year will give way to softer activity in the second half. Tighter financial conditions, geopolitical uncertainty, and lingering supply-chain disruptions are likely to weigh on business investment, while a gradually cooling labor market should temper consumer spending.
Inflation is set to move higher over the coming months, with Ofgem’s latest increase in the energy price cap alongside higher crude costs adding to price pressures. For now, inflation expectations remain well anchored, and monetary policy remains restrictive, leaving the Bank of England comfortable maintaining rates at current levels. A lasting energy shock could force the central bank to change course in the coming months.
The U.K.’s new prime minister, Andy Burnham, faces many of the same constraints as his predecessors: demands for higher public spending, elevated bond yields, and financial markets that remain sensitive to any signs of fiscal slippage. Burnham has pledged fiscal discipline and appointed former defense secretary John Healey as Chancellor to reassure investors. But a series of spending promises, including lower household energy bills, higher defense spending and potential tax relief for lower earners, could increase pressure on public finances. As a result, tax increases in the autumn budget appear increasingly likely, particularly if renewed tensions in the Middle East push inflation higher and weigh on economic growth.

Japan

First quarter growth was revised down to a still-solid 1.8% annualized pace, and incoming data point to continued resilience. The June Tankan survey showed business sentiment holding up well despite rising costs, while AI-related demand should continue to support exports. However, higher energy prices and elevated uncertainty are likely to weigh on consumption and investment. Fiscal concerns have resurfaced as Prime Minister Sanae Takaichi's new policy guidelines place less emphasis on achieving a primary budget balance and greater focus on reducing the debt-to-GDP ratio. With few details on how the ambitious investment plan will be financed, markets are growing more wary of Japan's longer-term fiscal outlook.
Persistent yen weakness, rising energy costs, ascending yields and growing fiscal concerns are likely to encourage a more proactive policy stance. We expect the BoJ to deliver an additional rate hike before year-end as it seeks to contain inflation risks and avoid falling behind the curve.

China

China remains relatively insulated from the direct impact of energy market disruptions, but domestic challenges remain a significant headwind. Economic growth slowed to 4.3% year over year in the second quarter, down from 5.0% in the first quarter and marking one of the weakest performances outside the pandemic period. Domestic demand remains subdued, with retail sales rising just 1.3% this year and fixed-asset investment declining 5.7%. Softer auto sales following reductions in electric vehicle subsidies and continued stress in the property market are weighing on activity. Infrastructure investment is in contraction territory, underscoring the economy's ongoing struggle to generate durable growth.
The slowdown in China strengthens the case for additional policy support, but Beijing appears reluctant to deploy another large-scale stimulus package. With exports still providing an important source of growth, policymakers are likely to rely on targeted and incremental measures rather than a broad-based campaign.

Australia

Australia's economy appears to have lost some momentum after a modest pickup late last year. Activity in the first quarter was held back by soft private and government consumption, and a sharp drag from net exports. Business investment, particularly in data centers and other AI-related projects, was the only bright spot. Wealth has been reduced by falling house prices, a consequence of tighter monetary conditions. This will continue to weigh on consumer spending, leaving growth softer in the balance of the year.
After three consecutive rate hikes, the Reserve Bank of Australia (RBA) paused in June amid softer domestic momentum. But inflation is still elevated and poised to rise further. Therefore, the tightening cycle may not be over just yet. With the RBA maintaining its focus on price pressures, we now expect one additional rate hike this year.

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Frayed Nerves

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