Fiscal expansion to propel US economy in multispeed world

Look for the U.S. economy to shake off its growth scare from the second half of 2025 and outperform expectations in 2026 as AI spending and fiscal expansion provide support. Europe, on the other hand, could lag consensus estimates because the front‑loading of tariffs in 2025 has drained meaningful manufacturing demand. In emerging markets, inflation and debt levels are reasonably under control, but tariffs are a wild card whose effects may take years to play out.

Fiscal expansion to strengthen U.S. capex tailwind

AI‑related capital expenditure (capex) has significantly boosted U.S. growth in 2025, and the capex incentives in the “One Big Beautiful Bill Act” (OBBBA) should only strengthen that tailwind next year. The beneficial effects of the Federal Reserve’s (Fed) late‑2025 rate cuts will add to the U.S. economy’s health in 2026. The labor market may be able to pull out of its stalemate between a low level of jobs added and minimal layoffs, moving toward expansion.

But inflation remains an overarching risk. With U.S. government debt at more than 120% of gross domestic product (GDP)¹ even as inflationary policies such as tariffs and immigration restrictions have a growing impact, the Fed will have difficulty returning inflation to its 2% target. Expectations for rate cuts in 2026 seem to overestimate the amount that the central bank will ease, and it may not be able to lower rates next year at all.

ECB could lean dovish

There was much front‑loading of European exports to the U.S. in 2025 to get ahead of tariff implementation, so eurozone manufacturing may be weaker than expected in 2026. This could surprise the European Central Bank (ECB), shifting its policy stance more dovish. Germany’s very large fiscal expansion is likely to drive German bund yields higher, in turn dragging all eurozone yields up. This tightening in financial conditions would be another factor leading the ECB to ease. There is also the risk of currency‑driven cuts if the euro strengthens beyond USD 1.20.

Political pressure in the UK is likely to drive some fiscal consolidation, albeit from levels that are quite expansionary. In response, the Bank of England should be able to ease rates more than is currently priced in.

Japan has overcome the opposite problem of other developed markets: deflation. In fact, the Bank of Japan (BoJ) appears to be behind the curve on tightening monetary policy. We expect labor shortages to cause wage inflation, building on the existing food inflation. With Japan’s new government, more fiscal stimulus is likely, adding fuel to inflation and leading the BoJ to eventually hike policy rates by more than expected.

Inflation under control in emerging markets

Inflation and debt levels are under control in emerging markets—particularly in Asia—relative to their history. In contrast with developed economies, emerging markets have made strides toward reducing their debt burdens over the last 10 to 20 years. Emerging market growth looks decent, if a bit on the sluggish side. The global trading system has proved to be reasonably adaptable to tariffs so far, but the ultimate impact on emerging markets will take years to play out.

The tariff situation with China remains particularly unsettled. The country’s “anti‑involution” campaign to reduce production of commonly exported goods should increase their prices, further complicating global trading relationships. Chinese domestic economic data are likely to continue to soften, and its housing industry remains under pressure. However, the People’s Bank of China seems reluctant to ease, preferring to use quantity‑based tools to allocate credit to favored sectors, although one rate cut in early 2026 is not out of the question.

Key takeaway
The U.S. economy is shaking off the 2025 growth scare, but the eurozone may lag as tariff front‑loading weighs on manufacturing.

 

 

Appendix

Financial Terms: Investors in the U.S. and Canada, for a glossary of financial terms, please go to troweprice.com/glossary.

Investment Risks:

Active investing may have higher costs than passive investing and may underperform the broad market or passive peers with similar objectives. Each person’s investing situation and circumstances differ. Investors should take all considerations into account before investing.

International investments can be riskier than U.S. investments due to the adverse effects of currency exchange rates, differences in market structure and liquidity, as well as specific country, regional, and economic developments. The risks of international investing are heightened for investments in emerging market and frontier market countries. Emerging and frontier market countries tend to have economic structures that are less diverse and mature, and political systems that are less stable, than those of developed market countries.

Commodities are subject to increased risks such as higher price volatility, geopolitical and other risks. Commodity prices can be subject to extreme volatility and significant price swings.

Inflation-Linked Bonds (Treasury Inflation Protected Securities in the U.S.): In periods of no or low inflation, other types of bonds, such as US Treasury Bonds, may perform better than Treasury Inflation Protected Securities (TIPS).

Investing in technology stocks entails specific risks, including the potential for wide variations in performance and usually wide price swings, up and down. Technology companies can be affected by, among other things, intense competition, government regulation, earnings disappointments, dependency on patent protection and rapid obsolescence of products and services due to technological innovations or changing consumer preferences.

Because of the cyclical nature of natural resource companies, their stock prices and rates of earnings growth may follow an irregular path.

Financial services companies may be hurt when interest rates rise sharply and may be vulnerable to rapidly rising inflation. Health sciences firms are often dependent on government funding and regulation and are vulnerable to product liability lawsuits and competition from low-cost generic product.

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