Economic resilience meets renewed inflationary pressures

Key points

• Economic growth remains resilient across major developed economies despite geopolitical uncertainty.
  
  
• In the UK and parts of Europe, inflation has moderated but central banks remain cautious.
  
  
• AI-related investment continues to support activity, especially in the US and parts of Asia.

Our economic outlook 

United States

Refining the monetary policy stance​

Economic growth continues to demonstrate resilience, with activity tracking at a pace consistent with an economy expanding at over 2%. Business investment remains a notable source of strength. Investment ran at a 9.6% pace through the second quarter of 2026, exceeding our strong expectations coming into the year by over two percentage points. We expect this capital expenditure cycle to remain an important contributor to growth through 2027. Consumer spending is also evolving broadly in line with expectations, supported by tax policy tailwinds and the continued benefits of elevated household wealth. Softer real income growth presents a potential headwind to consumption during the second half of this year.

The labour market remains fundamentally stable, with a broad range of indicators suggesting conditions remain close to neutral and consistent with overall health. We believe that the August employment report of 162,000 jobs created was stronger than underlying conditions suggest, but it did reinforce our view that cyclical labour conditions have improved modestly over the last few months. We have revised our year-end unemployment rate forecast down from 4.6% to 4.4%. We attribute about half the decline in the unemployment rate since November 2025 to the noncitizen labour force, a group that represents about 10% of the overall US labour force. Immigration policy and declining noncitizen survey response rates are among the reasons for the drop.

Inflation continues to be distorted by measurement issues and temporary factors; however, underlying price pressures appear to be stuck in a range just below 3%. The Federal Reserve raised its policy rate by 25 basis points at its 16 September meeting. We anticipate another rate hike by year-end, which we view as a recalibration of policy and the removal of prior accommodation rather than the start of a more sustained tightening cycle at this point.

United States economic forecasts

Notes: GDP growth is defined as the fourth-quarter-on-fourth-quarter change in real (inflation-adjusted) GDP in the forecast year compared with the previous year. The unemployment rate is as at December of each year. Core inflation is the year-on-year percentage change in the Personal Consumption Expenditures Price Index, excluding volatile food and energy prices, as at December of each year. Monetary policy is the upper end of the Federal Reserve’s target range for the federal funds rate at year-end.

Source: Vanguard. 

United Kingdom

Energy prices and labour market conditions build a case for rate hikes

UK real GDP grew 0.4% in the second quarter, driven by strength in the services sector and rising business investment. This follows firm growth of 0.6% recorded in the first quarter, though seasonal outliers have historically led to higher first-half growth compared with the second half of the year. Economic activity will likely soften through the rest of the year amid higher energy costs and tighter financial conditions. Nonetheless, risks to our 1.1% full-year GDP growth forecast tilt to the upside given recent strength in data, including solid purchasing managers’ surveys in July, August and September.

Concurrently, the labour market has shown signs of stabilisation, with private sector payrolls flat and high-frequency surveys pointing to a modest improvement in the second half of the year. This comes after a year and a half of softness as employment adjusted to the government’s tax increase on employer National Insurance contributions.

For the inflation outlook, we have revised our headline CPI forecast upward, driven largely by a rise in motor fuel prices. We now see headline inflation ending the year at 3.5% and core inflation at 2.6%. UK household energy bills are particularly sensitive to the recent rise in natural gas prices. 

Longer-term household inflation expectations remain elevated, which is likely a consequence of inflation having not sustainably fallen back to 2% since the 2022 shock triggered by the war in Ukraine.

The Bank of England announced on 17 September that it would keep the bank rate on hold at 3.75%, but the tone of the announcement shifted to being hawkish, with several policy committee members indicating they could support a rate hike if energy costs remain elevated. We have increased our year-end 2026 bank-rate forecast by 25 basis points, and we foresee an additional rate hike in 2027, taking the bank rate to 4.25%. 

United Kingdom economic forecasts

Notes: GDP growth is defined as the annual change in real (inflation-adjusted) GDP in the forecast year compared with the previous year. The unemployment rate is as at December of each year. Core inflation is the year-on-year change in the Consumer Prices Index, excluding volatile food, energy, alcohol and tobacco prices, based on the fourth-quarter average for each year. Monetary policy is the Bank of England’s bank rate at year-end.

Source: Vanguard. 

Euro area

Higher energy prices pose a hawkish risk for the ECB

Despite the energy shock stemming from conflict in the Middle East, economic activity in the euro area has proved resilient. Economic growth is tracking above our 0.8% forecast for 2026, with strength that has been broad-based across major economies and driven by domestic demand.

That said, we see only modest pass-through of German fiscal stimulus in the industrial production data so far. Spending on military equipment has accelerated in the last year, but this is only a small part of total production. More prominent sectors that should be exposed to infrastructure-related spending – including construction, basic metals, and machinery and equipment – have yet to experience a material upswing.

Within the labour market, the euro area unemployment rate remains remarkably stable at 6.4%. However, the aggregate headline masks significant divergence across countries. German employment growth is negative amid unfavourable demographics and a continuing industrial recession, while the French labour market is undergoing cyclical weakness. This contrasts with strong growth in Spain, where the rate of job creation is exceeding the immigration-led increase in labour supply.

Regarding inflation, both crude oil and natural gas prices have moved higher in the past month. This, coupled with widening profit margins for refined fuel products, raises the risks of second-round effects building into the system. We have increased our forecasts for core inflation to 2.5% for both 2026 and 2027, which is above the 2% target set by the European Central Bank (ECB).

The ECB announced a 25-basis-point increase of its policy interest rate to 2.5% on 10 September, which represented its second hike of 2026. Our forecast has called for just two ECB rate increases this year. However, given higher energy prices and the upward risks to inflation, we foresee an additional rate hike this year and another in 2027.

Euro area economic forecasts

Notes: GDP growth is defined as the annual change in real (inflation-adjusted) GDP in the forecast year compared with the previous year. The unemployment rate is as at December of each year. Core inflation is the year-on-year change in the Harmonised Index of Consumer Prices, excluding volatile energy, food, alcohol and tobacco prices, based on the fourth-quarter average for each year. Monetary policy is the European Central Bank’s deposit facility rate at year-end.

Source: Vanguard. 

China

Weak growth adds pressure for quicker policy delivery

China’s economic activity has weakened broadly so far in the third quarter, amid a widening divergence between resilient exports and subdued domestic demand. Retail sales, fixed-asset investment and industrial production have all fallen short of market expectations, even as export growth has remained robust. Housing prices in some of China’s largest cities have shown early signs of stabilisation, while broader real estate conditions remain weak elsewhere, with nationwide housing sales and real estate investment continuing to contract.

Looking ahead, exports are likely to remain relatively resilient in the near term, supported by the ongoing global AI investment cycle and demand for technology-related goods. However, the outlook for external demand is becoming increasingly uncertain. Rising trade tensions, including tariffs and anti-subsidy measures, may not immediately affect the health of exports, but are likely to increase both the economic and political costs of relying on foreign demand to absorb excess domestic capacity. In addition, moderation in AI-related capital expenditure, tighter technology restrictions or weaker global demand could weigh on one of China’s few remaining sources of growth.

Against this backdrop, policymakers are likely to shift policy implementation into a higher gear in the coming months as downside risks to growth continue to accumulate. We expect additional measures aimed at supporting domestic demand and stabilising economic activity. Despite this, policy easing is likely to remain targeted and incremental rather than evolve into broad-based stimulus. We expect the People’s Bank of China to maintain ample liquidity conditions and rely more heavily on structural monetary policy tools to direct credit towards priority sectors. Broad-based policy-rate cuts appear less likely in the near term.

China economic forecasts

Notes: GDP growth is defined as the annual change in real (inflation-adjusted) GDP in the forecast year compared with the previous year. The unemployment rate is as at December of each year. Core inflation is the year-on-year change in the Consumer Price Index, excluding volatile food and energy prices, as at December of each year. Monetary policy is the People’s Bank of China’s seven-day reverse repo rate at year-end. 

Source: Vanguard.

Japan

Bank of Japan hikes amid heightened inflation risk

The Japanese economy continues to expand at a moderate pace. Export resilience, strong wage growth, recovering consumer spending, solid corporate investment and increasingly supportive fiscal policy are underpinning economic strength.

Rising wages and stronger household spending, along with an economy running above its estimated sustainable capacity, suggest inflation is becoming more self-sustaining and demand-driven. Although services inflation continues to lag goods inflation, sustained wage growth should enable firms to pass higher labour costs through to consumers more effectively over time. This would support a further pickup in services inflation and reinforce the durability of the inflation cycle.

On 18 September, the Bank of Japan (BoJ) decided to raise its policy interest rate by 25 basis points to 1.25%. Policymakers assessed risks to growth as broadly balanced while judging risks to inflation as tilted to the upside. This reflects the potential for a further shift in corporate wage- and price-setting behaviour, alongside continued increases in medium- and long-term inflation expectations. Increasingly, the BoJ must balance inflation expectations, currency stability and rising government bond yields, making policy normalisation as much about credibility as inflation management.

We expect an additional 25-basis-point-rate hike by the end of 2026, which would take the policy rate to 1.5%. The timing of a hike will depend on incoming inflation, wage and activity data, as well as the extent of yen weakness and its implications for inflation expectations.

Japan economic forecasts

Notes: GDP growth is defined as the annual change in real (inflation-adjusted) GDP in the forecast year compared with the previous year. The unemployment rate is as at December of each year. Core inflation is the year-on-year change in the Consumer Price Index, excluding volatile fresh food prices, as at December of each year. Monetary policy is the Bank of Japan’s year-end target for the overnight rate. 

Source: Vanguard.

Asset-class return outlook

Vanguard has updated its 10-year annualised outlooks for broad asset class returns based on the most recent run of the Vanguard Capital Markets Model® (VCMM), based on data as at 30 June 2026.

Our 10-year annualised nominal return projections¹, expressed for local investors in local currencies, are as follows:

United Kingdom (British pounds)

Euro area (euro)

Switzerland (Swiss francs)

¹ The figures are based on a 2-point range around the 50th percentile of the distribution of return outcomes for equities and a 1-point range around the 50th percentile for fixed income.