Markets are underestimating the persistence of inflation

In our 2026 outlook, we highlighted that the conditions were in place for nominal growth to accelerate through 2026, given loose policy settings. We also argued the market was underestimating a pick-up in inflation this year from already sticky levels and that recession and stagflation were tail risks. The first few months of the year, before the start of the US-Iran conflict, appeared to corroborate our outlook as nominal growth data and lead indicators started to pick up. In parallel, inflation was beginning to accelerate in some G7 economies, though the market continued to price a benign inflation outlook in the belief that AI would anchor prices in the short and medium term.

Positive outlook meets stagflationary shock

The US-Iran conflict has abruptly moved stagflation from a tail risk to a live risk that could undermine the growth momentum we observed at the start of the year. The scale of its impact on the outlook for 2026 and beyond will depend on two key factors:

• how high, and for how long, energy prices rise, with the fallout ratcheting up over time; and
• how policymakers respond, given that significant additional fiscal support or tolerance of higher inflation could have the unintended consequence of amplifying the shock.

Markets still priced for a best-case scenario

At the time of writing, markets still seem mostly priced for a relatively quick and lasting resolution to the conflict and the ensuing normalisation of energy flows and prices as well as growth and inflation.

If that prediction turns out to be broadly right, the market is likely to re-engage quickly with the strong, policy-driven growth outlook. The spike in energy prices and the broader uncertainty resulting from the conflict would likely reduce the global growth rate in the second and third quarters of this year, but only temporarily. We think many central banks would try to look through the shock and leave policy unchanged. In this scenario, a still-supportive policy backdrop should help to drive a reacceleration in growth over the remainder of 2026.

This outcome would be largely positive for risk assets. Markets would likely revisit questions that were top of mind before the start of the conflict, notably:

• whether the disinflationary impact of AI will be sufficient to offset structurally accelerating inflation; and
• the extent of diversification away from US dollar assets as tariffs and institutional volatility impact the flow of capital into the US.

Risk increasingly skewed to rising energy prices and inflation

However, we think the risk is increasingly skewed to a more sustained rise in energy prices and inflation.

First, drawing on the work of our commodity team, we believe there is a growing risk of oil prices remaining high. Even if the Strait of Hormuz is reopened in the coming weeks, our commodity team expects oil prices to average in excess of US$100 per barrel this year.

Second, policymakers are accommodating the energy shock. Monetary policy was loose and fiscal policy was stimulative before the conflict, and both have been loosened further since. The rise in inflation expectations has pushed average real rates across developed markets into negative territory. Financial conditions are looser than they were at the end of February, and fiscal policy at the margin has been loosened further.

A significant source of regional/country divergence
The hit to growth from a sustained energy shock is not evenly distributed. Asia and Europe are the most affected. By contrast, in the US, as a marginal net energy exporter, trade gains have helped to offset the squeeze on household incomes and corporate margins from higher fuel costs. And for some large commodity exporters, this shock is even a net positive for growth, given the associated trade gains.

Further weakening of already stretched policy credibility
Since the outbreak of the COVID pandemic, policymakers across the developed world have maintained persistently loose policies. While this stance helped the global economy weather the pandemic, Russia’s invasion of Ukraine and now the US-Iran war, it has eroded the monetary and fiscal credibility earned over the preceding two decades.

• Governments have run consistently large fiscal deficits since the pandemic, despite a nominal growth boom. In response, the market has priced in more risk premia for governments, and the worst offenders have seen some of the largest increases in risk premia.
• Central banks, meanwhile, have persistently kept monetary policy loose. As a result, medium-term inflation expectations are now running above the 2% target in most developed markets and by some significant margin in Japan, the UK and the US.

Until these loose policy trends come to an end, the resulting upward pressure on term and inflation premia underpins our view that government bond yields are structurally on an upward trajectory and that curves can keep steepening structurally too.