Economic backdrop
US
For the US economy, our 2026 theme has been one of ”green shoots” supporting a cyclical acceleration. This seemed to be cruising right along and then it encountered an oil-shock speed bump. While the shock was largely contained to the second quarter, its implications will likely linger in future inflation prints, making the Federal Reserve’s job more challenging.
Starting the year there was a noticeable shift toward a broadly positive tone in the Fed’s regional economic report, better known as the Beige Book. This broad-based pickup was echoed by positive developments in cyclical indicators like the Institute for Supply Management’s manufacturing index, which had been negative for about 3 years. That trend extended to the labor markets, where we saw the key private ex-healthcare component (which comprises over 70% of total labor market) start to pick up after a full year of contraction in 2025. And then war broke out and oil prices spiked.
Next to a central-bank-driven tight monetary policy, an exogenous shock is a notorious culprit for ending a cycle. This time was no different as talk of $200 oil engendered fears of a punitive gasoline ”tax” hitting an already price-conscious consumer. However, the fear largely surfaced in the spot market. In the futures market, the out quarters (fourth quarter 2026 and first quarter 2027) didn’t see nearly the same increase. In fact, the average oil contract over that time period largely oscillated in the $70-a-barrel range, a price consistent with the 2023-2024 levels. Said another way, the market was seeing through the short-term impact, not seeing the long-term destruction of infrastructure and thus pricing in more normalized oil prices in coming quarters.
While the Iran negotiations continue, it is important to separate the lens of diplomacy from the market lens: The markets don’t care about the perfect diplomatic solution being attained, they care about the preservation of earnings power and capital-producing infrastructure, which is largely the current situation. While there is always the risk of a flare-up, the Iran conflict is increasingly shifting to the back burner as the focus transitions more to the underlying economic fundaments. Translation: Speed bumps crossed, back to the ”green shoots” narrative and, in conjunction, the Federal Reserve.
In recent months, the Fed has seen a shift in tone as the hawks have overtaken the main narrative from the doves, driven by lasting inflation fears caused by higher oil prices, et al. As of the June Federal Open Market Committee meeting, the current voting split is 50/50, with new Fed Chairman Kevin Warsh abstaining from supplying forecasts/dots on the dot plot projection. This sets up to be the main event at future Eccles Building meetings: Does uncomfortable inflation persist? Or do the nascent dis-inflationary pressures take hold and soften the inflation outlook? We are in the latter camp and thus see opportunities in the front-end of the rates market as it has priced in the start of another hiking cycle.
Europe
The region was hit by a fresh energy shock due to the conflict in Iran. As a large net importer of fossil fuels, Europe remains exposed to higher oil and gas prices, and any increase in energy markets amounts to a negative terms-of-trade shock for the region. That shock was much smaller than the one seen in 2022, but it comes at a less favorable moment: Fiscal space is more limited, debt burdens are higher and governments face additional spending demands—particularly in defense. As of this writing, the recent deal between the US and Iran has helped lower oil prices. Gas prices, however, remain relatively elevated and will likely only come down over time.
External pressure from both the US and China is also encouraging a greater sense of urgency around European cohesion, including further integration and a stronger push for greater independence in energy and technology. If these efforts are implemented effectively, they could provide constructive medium-term support for growth and resilience. But those pressures remain a risk if not appropriately addressed.
Consumer demand has supported growth in recent years, bolstered by real wage gains as inflation eased and nominal income growth remained relatively firm. We still see the labor market and past income gains as important buffers, but the latest energy shock is clearly weighing on sentiment. Consumer confidence has weakened, services expectations have softened and the outlook for domestic demand has become more fragile.
We also think Europe continues to face an unsettled external backdrop. US tariff policies remain a drag, while uncertainty linked to geopolitical tensions has made global supply chains more vulnerable. As an open economy, Europe remains sensitive to shifts in trade patterns and export controls. Europe is dealing with a less supportive geopolitical environment. Policy decisions from the US administration have had a negative effect on Europe: first through tariffs and more recently through the consequences of the conflict with Iran.
At the same time, we do not think the outlook is uniformly weak. Europe still benefits from several supportive structural forces. Investment should continue to receive backing from the German fiscal package, broader European Union funding, investment in artificial intelligence (AI) and the drive to strengthen infrastructure and security capacity. We also see scope for faster AI adoption to modestly bolster productivity over time. Improved energy supply conditions, including greater liquid natural gas availability and further growth in renewable generation, should also help reduce some of the terms-of-trade pressures. In other words, while the latest energy shock has delayed the recovery, it has not removed the medium-term supports that were already in place.
Performance across member states is also likely to remain uneven. Spain continues to stand out, supported by robust domestic demand, strong services activity and a dynamic labor market. Germany should benefit more clearly from fiscal support over time but remains exposed to industrial and energy-related weakness in the near term. France continues to face the dual challenge of political uncertainty and limited fiscal flexibility, while Italy’s recovery remains fragile. This unevenness matters because it implies that Europe’s recovery is unlikely to be broad-based.
Looking ahead, we expect euro-area growth to remain soft in the near term before gradually improving. In our base case, activity effectively stalls around the middle of 2026 and then recovers progressively. That leaves overall growth below potential in both 2026 and 2027. Our central view is that the recovery has been pushed back rather than cancelled.
On inflation, we think the picture has become more complicated. Headline inflation has already moved higher due to the energy shock. We also expect some pass through into core and food prices. Even so, we would distinguish the current episode from the more broad-based inflation surge of 2022–23. Demand conditions are softer today and wage disinflation was already underway. That should help prevent a renewed inflation spiral. Over the medium term, we continue to expect inflation to move back down and ultimately fall below target in 2027.
That inflation profile leads us to a more cautious, but still relatively hawkish view on the European Central Bank (ECB). We believe the ECB is likely to place greater emphasis on avoiding any de-anchoring of inflation expectations than it did earlier in the year, when the discussion was more focused on downside inflation risks. In our base case, we expect two ECB rate hikes in 2026, taking the deposit rate to 2.5%. Once the inflation impulse fades, we would then expect the ECB to reverse part of that tightening toward the end of 2027.
United Kingdom
The UK economy is also navigating a difficult environment, although the underlying mix differs somewhat from that of the euro area. In our view, the dominant theme is that a cyclical upswing has been delayed rather than derailed. The renewed rise in energy and commodity prices is a clear headwind and it comes at a point when domestic demand was already vulnerable to tight financial conditions and fading fiscal support. As a result, the near-term profile for growth looks softer, with households and domestically oriented businesses likely to remain cautious. Elevated uncertainty, weak confidence and still-restrictive financing conditions all suggest that private demand will remain subdued through much of 2026.
Recent developments in the labor market reinforce that message. We see several drivers behind ongoing weakness. First, there are early signs that AI adoption is beginning to affect hiring, most visibly in vacancies and in parts of the information and communications sector.
Second, higher labor costs have already weighed on payrolls in lower-paid sectors. Third, and most importantly for the coming quarters, broader economic weakness is likely to keep employment growth subdued.
At the same time, we think it remains important to recognize that the longer-term economic effects of Brexit are still visible in the UK economy. Official estimates continue to suggest that the post-Brexit trading relationship with the EU reduces long-run UK productivity relative to remaining in the EU, while external research has also pointed to a meaningful drag on the level of output.
Even so, we remain more constructive on the medium-term UK story than the near-term narrative alone would suggest. One reason is that we continue to see signs of a capex-led growth model emerging. The UK data already shows evidence of the broader AI adoption and investment cycle and we think both can make a more meaningful contribution to growth over time.
On inflation, we expect another externally driven rise before inflation gradually heads back toward the target. Energy inflation is likely to account for much of the near-term pressure, while food inflation may also firm. By contrast, we continue to expect underlying services inflation to moderate as wage growth slows. Taken together, this leaves a profile in which inflation remains uncomfortable in the short run, peaks above target and then declines over the course of next year. Our central expectation is that inflation will move back toward the 2% target by the end of 2027.
That backdrop explains why we expect the Bank of England (BOE) to remain cautious. In our base case, we think the BOE is more likely to stay on hold through 2026 than to react mechanically to the near-term rise in inflation.
Over the medium term, we think the UK’s economic trajectory will depend heavily on whether it can generate stronger productivity growth. If productivity improves and interest rates decline gradually, business investment should strengthen and firms are likely to become more capital intensive over time. However, the fiscal backdrop is unlikely to provide much support, with ongoing consolidation pressures still acting as a restraint on domestic demand.
Global corporate credit research overview
- Consumer-facing companies are operating in a more strained customer environment, driving greater discounting to sustain volumes and weighing on margins—a dynamic likely to continue
- Industrial sector companies remain relatively resilient, especially for companies exposed to aerospace and defense, infrastructure and data center-related end markets, with potential downside related to economic activity, consumer sentiment and trade policy implication
- Financial sector companies are seeing stable credit quality and earnings remain solid
- Leverage ratios for corporate issuers and capital adequacy levels for financial firms remain healthy across most sectors
Trade policy/tariffs have impacted demand, while the Middle East conflict has increased energy costs, supply chain risks and inflationary pressures. Even with a ceasefire, it will take several quarters for energy and commodity flows to normalize, while re-escalation would increase stagflationary risks. Having said that, we expect some resolution and continued modest global economic growth. Balance sheets should remain healthy, contributing to stable credit fundamentals in most sectors.
Overall, wage growth has slowed but is stabilizing, reflecting a resilient labor market and steady unemployment. Fears that AI-driven job losses would meaningfully weaken employment have not yet emerged. However, wage gains for lower- and middle-income households continue to lag higher-income groups, contributing to growing financial strain for those two groups.
Consumers remain value-focused, with a continued shift toward private labels, led by lower- and middle-income cohorts under financial pressure. Elevated essential costs are constraining discretionary spending. Companies are relying more on promotions to support volumes, creating margin pressure amid soft demand. Further discounting may stabilize volumes but will likely come at the expense of margins.
Despite exposure to macro, trade policy and demand risks, industrial-sector fundamentals remain resilient, supported by stronger balance sheets, cost pass-through and continued efficiency improvements. At the same time, secular pressures are driving increased merger and acquisition (M&A) activity in the media and communications segments, which could result in negative credit rating pressure.
Accelerating AI demand is driving significant capital requirements for AI data center buildouts in the US and Europe, supporting growth primarily across the technology, infrastructure, natural gas and electric utility sectors. As agentic AI deployment advances, companies should realize efficiency gains. However, given the pace of the buildouts, evolving technology and uncertain monetization, the sector’s return profile remains unclear.
The financial sector’s outlook is stable, supported by healthy fundamental trends across banks and insurance. We are monitoring pricing pressures in certain property and casualty (P&C) lines including property reinsurance, certain financial lines and personal auto. Additionally, business development companies (BDCs) are facing heightened scrutiny given their lending exposure to software, which could be susceptible to AI disruption, contributing to elevated redemption pressure for the non-traded/perpetual BDCs. Finally, M&A activity has recently increased within the insurance sector, which follows a pickup in US bank M&A last year.
Leverage ratios remain relatively stable across most sectors, supported by earnings growth. Debt levels are rising but most of the growth is concentrated in data center hyperscalers, which have strong balance sheets and relatively low leverage. Interest coverage continues to modestly weaken, as low-coupon debt continues to roll off and be refinanced at higher rates. Most corporate issuers continue to benefit from strong investor demand and relatively easy access to capital. The stability in credit metrics remains a key element of our overall stable fundamental outlook.
Fixed income overview
Fixed income outlook
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