2026 Global Macroeconomic Outlook: trying to move past the Middle East conflict

Entering the second half of 2026, the Middle East conflict is still in the mix as a dominant macro theme. At this stage, it’s fair to say that hostilities have lasted longer than most observers (ourselves included) would have predicted—and may or may not be completely over just yet.

A tentative mid-June deal between the United States and Iran could ultimately bring the conflict to a conclusion, but many sensitive details have yet to be negotiated. As a result, even if the American and Iranian blockades of the Strait of Hormuz are lifted soon, we have low conviction that commodities traffic through the region will resume swiftly, with some degree of geopolitical uncertainty likely to persist through the rest of 2026.

What is clear is that the longer the geopolitical turmoil drags on, the greater the risk of adverse economic consequences. However, we can establish two things:

• Not all global regions are being affected equally. Most notably, being a net energy exporter or failing that, at least being in possession of significant oil reserves, definitely emerged as a mitigating factor for some countries. The longer the conflict persisted, the more pronounced the divergence between economies with energy-export capacity and those more reliant on imports became.
• The worse the fallout, the more apt central banks will be to maintain or adopt hawkish stances. In mid-February, there was a narrative circulating that most central banks were “at or near their neutral policy rates.” Over time, it got increasingly difficult for monetary policymakers to dismiss the conflict as a short-term disruption or a simple price shock—second-order inflation effects began creeping into forecasts, driving a more hawkish bent across most regions.

United States: still looking pretty strong

Like elsewhere globally, the Middle East conflict has altered the U.S. macroeconomic picture to some extent. That said, the impact on U.S. growth and inflation appears limited relative to other regions, reflecting the country’s position as a net energy exporter and other growth drivers still in place.

Beneath the geopolitical uncertainty, the overall macro backdrop is constructive. Earlier this year, our outlook pointed to the likelihood that easier monetary policy and fiscal support would provide strong underpinnings for the U.S. economy. There is, in fact, evidence of broadening economic activity despite the overseas conflict: Industrial production and business investment have strengthened, while consumption remains resilient. Barring a meaningful deterioration in the labor market or a sustained downturn in capital markets, consumer spending should continue to bolster growth.

We don't expect the U.S. Federal Reserve (Fed) to lower rates absent sustained improvement in supply-side pressures. Indeed, with growth solid, labor holding up, and inflation elevated, the case for easing has weakened and would likely only regain traction if the Fed saw signs of disinflation, or at least stable inflation combined with softness in either growth or labor.

At the same time, Fed tightening seems unlikely unless the conflict re-intensifies and extends well into the third quarter, which would rekindle inflationary concerns. Once supply-chain constraints loosen, the Fed may resume its path toward its long-run neutral rate (~3.1%). 

What we’re watching

There are nascent indications of incremental improvement in the jobs market, which could undercut any arguments for Fed easing. If employment tightens materially—a distinct possibility, given today’s underlying labor supply dynamics—the Fed’s scope to ease could diminish, perhaps shifting its policy stance more hawkish.

Market implications

Our focus remains on the long end of the yield curve. Earlier this year, falling yields hinted at a potential mortgage-refinancing wave that might boost growth. Now, rising yields pose the opposite risk: A sustained increase could begin to weigh on U.S. equity market performance and financial conditions.

Canada: a recovery on a short leash

Although Canada started 2026 with weak momentum, signs of stabilization emerged as some businesses began to adapt to U.S. sectoral tariffs still in place on steel, aluminum, autos, and other goods. However, a new complication arrived in March: The Middle East conflict drove oil prices above US$100/barrel, pushing Canada’s headline inflation to 2.8% in April, even as core measures eased to around 2%.

The Bank of Canada (BoC) now faces an uncomfortable balancing act: Hold interest rates steady at 2.25% to support a soft labor market (with the unemployment rate currently at 6.6%), or resume hiking rates if global energy prices don’t come down all that much and begin feeding into broader domestic inflation—a risk that BoC Governor Macklem has explicitly flagged.

Despite the unforeseen energy shock, we think the Canadian economy will grind through the year with sluggish but positive growth. Government spending on infrastructure, housing, and tax breaks for consumers is doing the heavy lifting so far. Non-U.S. exports have picked up slightly, though the gains are concentrated primarily in energy and gold, not in manufacturing.

Bottom line: We forecast full-year GDP growth of roughly 1.0%, with gradual acceleration into 2027.

What we're watching

The United States-Mexico-Canada Agreement (USMCA) formal review starts on July 1. While a deal is still possible, differences in trade positioning between Canada and the United States seem to have widened in recent months. The risk that Canada may face higher broad-based tariffs by the end of the year has therefore risen. 

Market implications

The S&P/TSX Composite Index has advanced roughly 11% year-to-date. We expect returns to moderate as energy tailwinds fade, but financial and materials companies should continue to perform well. Fixed-income returns may be muted with the BoC on hold and long-term U.S. Treasury yields higher. The Canadian dollar could appreciate modestly on narrowing rate differentials and higher commodity prices, but weak growth and USMCA uncertainty may cap any gains.

Europe: fiscal tailwind vs. energy headwind

At the beginning of 2026, we were broadly constructive on the euro area, supported by a stronger fiscal impulse, ongoing structural reforms, improving credit growth, and a fairly stable external backdrop.

However, because the Eurozone is a net energy importer with relatively high energy expenditures, the Middle East conflict clouded our outlook. As such, unless flows through the Strait of Hormuz return to normal quickly, economic growth—particularly the consumer spending component—may be affected, likely offsetting some of the boost from Germany’s defense and infrastructure spending. While our current economic assumptions do not point to a recession, they do imply weaker growth.

That said, this year’s oil price shock differs from the 2022 energy crisis, which was amplified by natural gas supply distortions feeding directly into electricity prices. That factor isn’t really in play this time around: The more recent situation has been mainly about oil products, so the overall impact will probably be smaller, albeit still a headwind. Further mitigating the price shock are softer labor-market dynamics, which should reduce the risk of wage-driven second-order effects.

With the European Central Bank’s (ECB) policy rate already within the estimated neutral range, policymakers will need to balance lower growth and higher inflation. Given that delicate balance, we don’t expect the ECB to undertake an aggressive tightening cycle unless it sees clear evidence that long-term inflation expectations are becoming unanchored, or that wage growth is reaccelerating. We therefore view the latest market expectations of multiple ECB rate hikes as being premature.

What we’re watching

Whether or not the deal to end the Middle East conflict proves lasting will ultimately determine the magnitude and persistence of the inflation/growth shock. The ECB’s responses will likely hinge on evolving inflation expectations and wage dynamics.

Market implications

European equities may remain under some pressure until there are no further shipping disruptions in the Strait of Hormuz. Amid inflation concerns, markets are already pricing in several ECB rate hikes, but weaker growth should limit the ECB’s scope to tighten.

United Kingdom: growth still under pressure

Despite stronger-than-expected first-quarter data, the United Kingdom’s (U.K.) economic growth is likely to stay subdued through 2026. Elevated energy prices and tight financial conditions have dampened both consumer demand and business investment, while monetary and fiscal support remain limited.

On monetary policy, the energy shock may have put the Bank of England (BoE) in a more hawkish stance. However, imminent rate hikes (currently priced in by markets) are not our base case because labor market dynamics are softening, with easing wage pressures limiting broader inflationary impacts. Moreover, U.K. monetary policy is already more restrictive than in other developed markets. Before the oil shock, markets expected the BoE to cut rates; subsequent repricing pushed the long end of the yield curve higher, feeding through to rising average mortgage rates and further squeezing households.

On fiscal policy, fragile public finances and heightened political uncertainty imply a tighter stance ahead. The energy crisis eroded some fiscal space by raising interest rates and lowering growth prospects. Meanwhile, the nation could soon see yet another change in leadership, continuing a revolving door of prime ministers in recent years, with the potential for a leftward shift toward more expansionary policies weighing on bond markets. Notably, U.K. gilt markets are constraining the government’s ability to provide fiscal support and tightening financial conditions across the economy.

What we’re watching

A rapid growth slowdown could pull forward BoE rate cuts, while clearer second‑round inflation effects could reinforce monetary tightening expectations. A new political regime could materially influence market sentiment.

Market implications

Gilt yields look poised to stay higher for longer. Markets appear too hawkish on BoE policy tightening. U.K. equities are likely to underperform most developed-market peers.

Japan: a structurally positive outlook

Despite a robust first-quarter print, we expect Japan’s real GDP growth to face near-term headwinds going forward. Deteriorating terms of trade, driven by higher energy prices and a weak yen, have posed upside risks to inflation and downside risks to growth. This potential stagflationary backdrop may afford the Bank of Japan (BoJ) some policy flexibility to “stand pat” on interest rates, as it awaits more data clarity on the global economic and geopolitical picture before proceeding with further rate hikes.

Meanwhile, Prime Minister Takaichi’s decisive victory in the snap election earlier this year, gaining a critical supermajority in the Lower House, has given the Japanese ruling coalition a strong mandate to pursue expansionary fiscal policy in support of the economy. This pro-growth stance, coupled with resilient global trade, underpins our structurally positive growth outlook over the medium term, even as we closely monitor economic and geopolitical developments in the second half of 2026.

What we’re watching

Japanese government bond (JGB) yields have risen to multidecade highs amid higher domestic inflation, BoJ rate-hike expectations, and deficit spending by the government. A new supplementary budget could fuel renewed concerns over JGB issuance and fiscal discipline.

Market implications

The yen may fall victim to the Japanese-style “impossible trinity,” meaning that a combination of expansionary fiscal policy, accommodative monetary policy, and a resilient currency likely cannot be sustained in practice. Despite recent intervention by the Japanese Ministry of Finance, the currency’s struggles may continue unless we see a meaningful reversal of the yen carry trade and a sharply hawkish policy shift by the BoJ.

China: “K-shaped” growth likely to persist

Solid first-quarter GDP growth has put China on track to meet its 4.5-5.0% growth target for 2026, though we expect momentum to moderate as the year progresses. Notably, China’s “K-shaped growth”—where the economy is based heavily on high-end manufacturing, capital expenditures, and strong exports, while domestic sectors generally lag—is likely to continue.

On inflation, while China’s Producer Price Index (PPI) has turned positive (driven by higher import prices amid elevated energy costs and strong AI demand), weak domestic consumption underpins muted pass-through effects to headline and core readings. This dynamic could weigh on producers’ profit margins and raise questions about the sustainability of reflation and implications for China’s equity market. That said, despite the imbalances in the economy, Chinese assets have held up well throughout the Middle East conflict. Diversification in energy dependency has helped to cushion the shock, as have oil-price controls and ample inventory levels.

Looking ahead, with growth broadly on track to meet target, Chinese leaders are preserving policy flexibility for now and appear to be in no rush to push for additional economic stimulus. However, should downside risks materialize, policymakers are well-positioned to adjust their approach accordingly.

What we’re watching

China’s equity outperformance observed over the past year has started to fade, especially relative to its North Asian peers, amid a confluence of headwinds, including a lack of meaningful savings reallocation into the market and underweight positioning in China on the part of foreign equity investors. We will be closely monitoring whether the second half of 2026 ushers in a more constructive backdrop for the equity market. 

Market implications

We expect the Chinese yuan to remain resilient going forward, supported by the country’s strong trade surplus and corporate currency-conversion flows.

EMs: navigating stagflation risks

Emerging-market (EM) economies have demonstrated notable resilience in the face of the energy price shock, with GDP downgrades thus far relatively contained. Looking ahead, while geopolitical uncertainties could continue to dampen the outlook, several supportive factors might help cushion the negative impact on economic growth.

Tariff and other policy uncertainties have eased from the peaks of “Liberation Day” 2025, buoying global trade volume and overall market sentiment. In addition, the ongoing AI/technology supercycle continues to underpin robust global demand. Fiscal policy across many EMs, while undergoing gradual consolidation to rebuild buffers, remains sufficiently flexible to deliver targeted support where needed.

That said, the outlook across EMs may become increasingly bifurcated in the coming months, especially if we don’t see a quick end to the Middle East conflict: Energy exporters and economies benefiting from AI-driven growth may outperform energy importers and structurally constrained economies with limited exposure to AI tailwinds.

What we’re watching

The rising threat of inflation, including second-round impacts on core readings and inflation expectations, combined with a slower growth outlook, put most EM central banks in a difficult position. While conventional wisdom calls for policymakers to look through exogenous shocks, deteriorating terms of trade and higher inflation pass-through risks may have created a dangerous feedback loop that could exacerbate currency weakness and weigh on growth.

As such, many EM central banks’ policy stances have turned more hawkish. We will continue to monitor how their responses might diverge as they navigate the challenge of managing stagflation risks.

Market implications

Sustained EM equity outperformance will depend on a softer U.S. dollar, the continuation of the AI cycle, and a durable manufacturing and trade backdrop.