The World in 2026: The AI ​​bubble will continue, fiscal and trade tensions, and China stuck between low growth and deflation

The past year has highlighted how influential a range of macro and market forces have become, from booming AI investment to lingering US-China tensions and the build-up of fiscal risks. These themes will continue to define the outlook for 2026, writes Neil Shearing, chief economist at Capital Economics Group.

The benefits of AI will continue to grow – and the market bubble will continue to inflate

The year 2026 will bring further evidence of the transformative potential of AI, but the economic gains will be unevenly distributed. The boost to economic growth that technology will deliver next year will be concentrated in the US and will come mainly from increased spending on building AI infrastructure. Productivity in the US is starting to show signs of improvement, but the short-term boost to growth will depend much more on investment than on an economy-wide increase in productivity. AI is already boosting the US economy: According to our estimates, it added about 0.5 percentage points to GDP growth in the first half of this year. We expect this to continue in 2026.

Elsewhere, however, the picture is less encouraging. AI adoption and related investment have been slower outside the US, and there is little sign that this gap will close anytime soon. This is one of the reasons why we expect Europe to continue to underperform. Our GDP forecasts for both the UK and the Eurozone are 1.2% and 1.0% respectively.

Optimism around artificial intelligence was a key reason why 2025 was another stellar year for stock markets. There is no doubt that equity valuations are high, especially in the US. But they're not yet as tight as they were during the last tech-driven equity bubble of the late 1990s, and earnings growth should remain solid. Therefore, we think stocks can continue to rise for a while: we expect the S&P 500 to rise to 8,000 by the end of 2026.

China will remain stuck between low growth and deflation

Although Europe lagged behind the US in AI development and adoption, 2025 was a year in which China closed the gap with America in key areas of AI technology. However, even as China challenges the US on the technological frontier, its overall economy continues to be hampered by deep structural problems. Underlying is a growth model that continues to prioritize supply over demand, leading to excess capacity and weak consumer spending. Policymakers are committed to addressing the problem, but imbalance will remain a defining feature of China's economy in 2026.

The authorities do not seem to consider the countervailing stimulus that would be needed if there were massive factory closings and job losses. And while fiscal policy will remain accommodative next year, it will not generate substantial growth in domestic demand. The next Five-Year Plan, to be published in March, is likely to include a target to increase the share of household consumption in GDP, but a major policy shift does not appear to be possible: early signs show that the main priorities of the Plan will be to maintain the effort to increase China's industrial self-sufficiency and compete in the field of high technology.

The bottom line is that economic growth is likely to remain weaker than anticipated. Our indicator of activity in China suggests that the economy is currently growing at around 3% year-on-year – we expect a similar pace of expansion in 2026. At the same time, the imbalance between supply and demand is likely to cause China's trade surplus to widen rather than narrow, and will continue to generate significant deflationary pressures. China's 10-year government bond yield fell below Japan's for the first time this year, and we expect the gap to widen in 2026.

The trade war is not over

The agreement reached between Presidents Xi and Trump in late October – and the series of agreements reached between the US and other trading partners in the second half of this year – did not end the trade war. Instead, 2026 will be a year in which the economic rift between the US and China will continue to evolve in unpredictable ways.

While the Xi-Trump deal removed the immediate risk of further tariff escalation, it did little to resolve tensions in the US-China relationship. Crucially, the one-year sunset clause creates the possibility of a new crisis at the end of 2026. The restrictions on global trade that were put in place in 2025 will not be removed next year.

Supply chains for critical goods are likely to continue to shift away from China, while the renegotiation of the US-Mexico-Canada trade agreement (USMCA) could give Washington the opportunity to tighten rules of origin, making it harder for Chinese firms to circumvent US tariffs by routing exports through Mexico. Investment and technology flows will also come under closer scrutiny and could face additional restrictions.

Central banks will continue to ease monetary policy — but Trump won't get the big cuts he wants

2026 will be a year in which most central banks will continue to ease monetary policy, but the pace of easing will vary widely and, in several cases, our forecasts deviate significantly from what markets are currently expecting.

In the US, a combination of a resilient economy and an inflation rate we expect to hover around 3% suggests interest rate cuts will come more slowly than investors anticipate. If the Fed follows through with another cut this month, we think there could be only one more cut in 2026. That would leave the federal funds rate in a range of 3.25-3.50%, compared to market expectations of below 3% next year. That could put the Fed at odds with President Trump, who has repeatedly called for lower borrowing costs. Our baseline scenario is that a change in Fed leadership in May will not fundamentally threaten the institution's independence or trigger a major policy shift, but it remains a clear source of risk.

In other regions, however, Capital Economics expects policy easing to be larger than markets currently anticipate. In the eurozone, a combination of weak growth and moderate inflation should allow the ECB to cut the deposit rate to around 1.5% next year, against market expectations of around 2%. And in the UK, we expect inflation to fall faster than both the Bank of England and markets anticipate. Together with planned fiscal tightening, this should push the Bank to cut interest rates to 3% by the end of the year – below the 3.5% currently priced in by markets.

Fiscal risks will continue to weigh on markets

Fiscal tensions that have rattled investors at various points this year will continue to weigh on markets in 2026. The public finances of several major advanced economies are on an unsustainable trajectory. France, the US and, to a lesser extent, the UK are running sizable budget deficits on top of already high debts. Italy's fiscal position is somewhat stronger, but public debt is high and the economy's growth rate remains low.

The key question is: how much public debt is too much? In practice, there is no single threshold beyond which a fiscal crisis becomes inevitable. Conversely, tensions tend to arise when an economic or political shock causes investors to reassess a country's fiscal outlook.

Economic shocks can never be ruled out, but we feel that politics will be the most likely catalyst for fiscal concerns in 2026. Signs that governments are losing their commitment to fiscal prudence, moving toward looser fiscal policy, or marginalizing individuals who are well-regarded in the markets could unsettle investors.

Potential triggers include growing concerns about the outcome of France's 2027 presidential election or a change of government in the UK.

Ultimately, a combination of interest rate cuts by central banks and a subtle increase in financial repression will generally keep government bond markets anchored. But the sharp, short sell-off triggered by fiscal concerns – similar to that seen in France, Britain and the US this year – is likely to recur at some point in 2026.