Global Economic Overview – May 2026

August has seen little progress in achieving an end to the hostilities in the Middle East. The MoU between the US and Iran expired on 17 Aug without an agreement leaving the situation in limbo. A return to direct military action may have been avoided, but neither are talks occurring. Instead, the US is now opting for a policy of economic isolation. This may actually be less helpful given that it will likely prolong the conflict and see Iran maintain its closure of the Strait of Hormuz. Regional tensions have also grown with the Houthis’ announced closure of the Bab el-Mandeb Strait and Red Sea to Saudi Arabia, complicating its ability to use its alternative port, Yanbu, outside of the Persian Gulf to export crude.

Chart 1: Shipping is now restricted across both the Hormuz and Bab el-Mandeb straits

Source: Investec Economics, Macrobond

Consequently, oil exports from the region were 38% below pre-war levels in July at 15mb/d*. LNG exports too remain well below pre-war levels, although that has been offset to a degree by higher output from the likes of the US. Understandably prices are higher, Brent sits at $86, still below its $118 peak, whilst UK natural gas is at its highest during this crisis. Futures curves remain downward sloping suggesting a diplomatic solution and an eventual end to energy supply disruption is the market’s base case. However to our mind the latest developments raise the risk of an open-ended situation where supply remains constrained driving an upward grind in energy prices. This is a situation which would not be helped by shrinking inventories, which thus far have acted as a shock absorber, hitting critically low levels.  

Chart 2: Energy futures curves are at or near their highest since the Iran conflict began

* IEA Aug OMR                                                                                            Source: Investec Economics, Macrobond

So what happens if energy prices do not fall? At current price levels we suspect that central bank thinking may not dramatically change as despite what would be a higher near-term inflation profile, negative base effects from energy prices would still push inflation lower next year. However oil prices at $100/bbl or above may become more problematic, especially for a prolonged period as it would fuel policymakers’ fears of second-round effects, ultimately pushing the debate over whether to remain cautious and holding policy steady, to taking a more proactive approach and raising rates. Interest rate markets are still assuming something akin to the latter given current rate curves, despite the downward slope in energy futures. 

Chart 3: Globally market expectations are factoring in higher rates and for longer

Source: Macrobond, Investec Economics 

What has surprised during the Iran conflict has been food price inflation, which rather than rising, has fallen in some geographies. However there are risks to this outlook. For one there is now a broad agreement that 2026/27 is facing a possible ‘super’ El Niño, a warming of ocean temperatures of 2% or more, which distorts weather patterns (mainly in the Southern Hemisphere), impacting harvests and pushing up commodity prices. How much this impacts consumer inflation varies by country, but taking a focus on Europe, this coincides with a local period of extreme heat and drought, which has seen harvest forecasts* cut 8% relative to 2025’s output. As such the risks to food prices through the course of 2027 is evidently upwards. 

Chart 4: El Niño and extreme heat in Europe pose risks to 2027 food prices

Our note on El Niño and the implications for UK inflation can be found here * COCERAL                         Source: NOAA

The ongoing situation in the Middle East remains a risk to global growth, but we do not believe recent developments have been sufficient for us to alter our global growth forecasts of 3.1% for both 2026 and 2027. Stepping away from the Middle East, one aspect of global growth that is eye-catching is the impact of AI. As we have previously noted US AI related capex has been a factor driving US expansion this year. But an uplift to growth from the AI drive is also evident in Asia amongst the major semiconductor producers, namely S. Korea and Taiwan, where GDP growth has outperformed expectations. 2026 growth in these economies is now expected at 3.4% and 10.9% respectively. 

Chart 5: AI’s demand for chips boosts 2026 growth prospects in Taiwan and S. Korea

Source: Investec Economics, Consensus Economics

A dominant theme in markets has been the grind higher in government bond yields; 30-year yields across the UK, US, Germany and Japan have all hit multi-year highs. Unsettling sovereign bond markets is increasing competition from AI corporate issuance. But also, long-standing concerns over government debt loads and deficits are a factor. We questioned whether there was an element of the 'sell-US' trade remerging too given the recent USD weakness, but that does not line up with the performance of US equity markets. The latest BofA Fund Managers survey points to investors becoming increasingly overweight US equities whilst Q2 results were extremely strong and not just concentrated in the tech sector either. 

Chart 6: Bond markets have been unnerved over the last few months  

* Federal Reserve nominal broad USD index. Source: Macrobond, Investec Economics 

Financial markets gave Fed Chair Kevin Warsh’s new communications strategy a thumbs down at the latest meeting, with the Chair failing to adequately explain 1) why the Fed held rates, 2) why three members would have preferred a 25bp hike, and 3) how the Fed viewed the outlook ahead. This caused some investors to doubt the Fed’s ability to meet the 2% inflation target on a sustainable basis, resulting in longer-dated Treasury yields rising. The FOMC’s thinking has become a little clearer in subsequent comments. These, alongside the minutes from the meeting, revealed a general unease over inflation on the committee, with ‘additional’ members prepared to vote for higher rates if the inflation outlook were to deteriorate further.

Chart 7: Warsh’s press conference failed to deliver a clear message (transcript as a word cloud)

Source: Investec Economics, Wordclouds.co.uk, Federal Reserve

However, these comments largely pre-dated a softer run of data recently (Chart 8). Q2 GDP was a touch weaker than expected, retail sales fell in July (albeit partly due to the varying timing of Amazon Prime Day) and the latest non-farm payrolls report showed a surprise 23k fall in jobs on the month, placing the employment side of the Fed’s dual mandate back into greater focus. Meanwhile, the latest US inflation print did not show much evidence of a broadening out of price pressures, implying limited secondary effects from the oil shock. We would describe economic conditions as steady with some bright spots (i.e. AI investment). We forecast 2.0% growth this year and next (prior: 2.1% & 2.0%).

Chart 8: Some weak economic data might prompt some FOMC members to think again on hikes

Source: Investec Economics, Macrobond

So where does this leave us on interest rates? Provided that oil prices follow the current curve, i.e. they fall, there should be some sizeable base effects next year that will help guide the headline measure of inflation lower. The latest Fed forecasts (at the time of the June meeting) see PCE inflation at 2.3% in Q4 2027, and 2.0% in Q4 2028. Recent benign core inflation helps this narrative. Given this and the recent tightness in financial conditions, we think the FOMC can just about get away with not tightening this year. Next year we will have a rotation of voting members with the more hawkish members rolling off, which alongside easing inflation data, should open the door for rate cuts in H2. However this is predicated on the situation in the Middle East not intensifying further.

Chart 9: Economists see rate cut(s) next year – financial markets disagree

Source: Bloomberg economists’ consensus, Investec Economics

One wildcard for the inflation outlook though is tariffs. The universal 10% tariffs expired at the end of July and in their place are 10-12.5% tariffs under Section 301 of the Trade Act. Their aggregate net impact though has been minimal with the effective tariff rate on our calculations shifting just marginally higher to 11.9% (Chart 10). But that is not to say that tariffs have taken a backseat. The US has just slapped 50% tariffs on around $20bn of Canadian imports after the pair failed to reach a trade agreement. Canadian PM Carney has quickly promised to match the new levies 'dollar for dollar', with measures due on 8 Sep. The situation could yet escalate further with Trump already retaliating to the retaliation with fresh tariff threats. 

Chart 10: The replacement tariffs have only marginally pushed up the avg. tariff rate 

Source: Macrobond, Investec Economics 

Tariff policy will also impact the fiscal outlook. The tariff refunds that had to be paid following the Supreme Court ruling on the legality of the IEEPA tariffs have resulted in a widening in the US deficit (Chart 11), pushing the national debt to over $40trn for the first time. This has been touted as one reason why longer-dated US Treasury yields have crept higher as of late. Other reasons include fears over the inflationary consequences of the ongoing Iranian conflict and also unease with the Fed’s new communication strategy. We also wonder whether the surge in private (mostly AI-related) debt issuance is ‘crowding out’ public sector debt. It is likely a confluence of all these factors. 

Chart 11: US budget deficit widens as tariff refunds are paid

Source: Investec Economics, US Treasury, Macrobond 

The sell-off in USTs (Chart 12) has seemingly hit the Treasury’s pain threshold, resulting in interventions in recent weeks. The first was when the US jointly intervened with the Japanese to prop up the yen (the US selling EUR) in a likely attempt to limit extra selling of USTs. The second was an additional surprise bond buyback notice, just two weeks after the regular quarterly announcement. The Treasury will at least double its long-dated buyback operations from $2bn to $4bn per operation, starting 9 Sep and ending 4 Nov (the day after midterms). The official reason was to improve liquidity, but we see it as a move to contain the rise in longer-dated yields. This would just be a temporary sticking plaster though, as unlike the Fed’s QE, it will require funding, most likely through greater issuance at the shorter end of the curve or using the TGA*.

Chart 12: Was the US Treasury’s buyback announcement about more than just liquidity?

The Treasury could fund the buyback by running down balances here, but this too would presumably eventually be refilled. 

Source: Investec Economics, Macrobond

Western Europe recorded abnormally hot and dry weather this summer (Chart 13). This has curbed agricultural output: early estimates are for substantially lower crop yields in Germany and France. In addition, there have been extreme wildfires, notably in France and Spain – again hitting agriculture but also some tourism. A further consequence has been much lower river flow in the dry areas than average, affecting water supply, irrigation and energy production. Industry is suffering too: 5% of German goods are transported by inland waterways, some of which can now carry only restricted loads, leading to higher logistics costs and possible output curbs. We expect all this to harm Q3 GDP growth.

Chart 13: Western Europe experienced record summer heat and very dry conditions this year 

Source: Copernicus Climate Change Service 

On top of that, the stalemate in Iran has led to a grind up in global energy prices, both spot and futures. This poses extra headwinds to the EU21 economy, given it is an energy importer. A related worry is that gas storage is refilling more slowly than usual going into the winter, leaving the possibility of a late scramble for LNG and then an economically damaging gas (and power) price spike in an attempt to reach the target fill level of 80% (Chart 14). Yet for now this remains a risk scenario, and our baseline case is more benign: even with drought effects built in for Q3, we have nudged up our ’26 GDP forecast by 0.1%pt, to 0.8%, on base effects from a firmer-than- expected Q2 outturn. Our ’27 GDP growth forecast remains at 1.6%, as before. 

Chart 14: EU gas storage is being filled ahead of the winter, but more slowly than in recent years

Source: Gas Infrastructure Europe (GIE), Macrobond and Investec Economics

When it comes to inflation, for our baseline forecasts we assume that oil prices evolve in line with the futures curve. (Central banks tend to do the same.) This still suggests that oil prices will decline, but over the next few months, less rapidly than a month ago. With this, we have adjusted our inflation forecast upwards too relative to last month. We now predict that inflation will average 3.0% this year and 2.7% next year, 0.2%pts and 0.3%pts higher than our forecasts in July. Our ‘core’ inflation forecasts (ex-food, energy, alcohol & tobacco) are unchanged for this year at 2.4% and just 0.1%pt higher for ‘27 (also 2.4%). We project though that a year from now, inflation could be closing in on the ECB’s target rate of 2% (Chart 15).

Chart 15: Higher oil price futures have pushed our inflation forecasts up relative to July’s

Source: Eurostat, ECB, Macrobond and Investec Economics

To ward off the scenario where the near-term rise in inflation becomes entrenched via higher wage growth, it looks highly likely to us that the ECB will choose to raise rates once more, most probably in September, by another 25bps. The market concurs, pricing in a very high probability of such a hike. Where our view differs from what is priced in though is with regard to policy rates after that. If our forecasts for inflation remain in play – events in the Middle East can of course change that – we think on-target inflation would look in sight soon enough for the ECB to keep rates steady for the rest of the year and to return to cutting rates in mid-2027. The market, meanwhile, prices in one extra hike by March ’27 and no cuts later that year as its mean outcome.

Chart 16: The market reckons on a visibly higher ECB deposit rate in ’27 than we do

Source: Macrobond and Investec Economics

Climate events, global geopolitical events and the response to these by central banks all have a role to play in affecting the value of the Euro. But politics within the Eurozone matters too. France is in the spotlight. The lack of a majority for any party in the Assemblée Nationale since the snap election in mid-’24 has made it very hard to put the public finances in order: France is projected to run a deficit of at least 5.0% of GDP this year. Amid heightened attention in bond markets on fiscal metrics, French 10y bonds have sold off more than their German counterparts (Chart 17) since end-July, which themselves have underperformed US bonds. This adds to debt interest costs and worsens the fiscal…

Chart 17: The selloff in French bond markets has been particularly pronounced recently

Source: Macrobond and Investec Economics

Joint EU bond issuance has been called for not just to facilitate defence expenditure, but to act as a European safe asset too. Voices from the ECB argue that a deep liquid EU debt market could gain …outlook even further. To stem the bleed, Finance Minister Lescure aims to submit a draft budget for next year particularly early, hoping to better the past two years by passing it before year-end. If this fails, stalemate may last beyond the presidential elections (their two rounds will be held on 18 Apr and 2 May ’27), a scenario that would likely hurt not only French bonds but quite possibly the Euro too. We expect this to be avoided, but we continue to expect EURUSD to be temporarily impacted by pre-election uncertainty in the US (in Q3 ’26) and in the Eurozone (in Q1 ’27; Chart 18). Our year-end ‘26/’27 forecasts remain $1.17 and $1.19. For EURGBP, we predict 86p and 88p, as we see market rate expectations as having greater scope to fall in the UK compared with the Eurozone. 

Chart 18: Pre-election uncertainty might lead to temporary swings away from EURUSD’s trend

Source: Macrobond and Investec Economics

Budget day is 28 Oct, with Chancellor (John) Healey set to raise expenditure in various areas, such as defence. Will he also raise taxes? Indeed PM Burnham has conceded the government might have to ask for 'a little bit more'. The good news is that there are no negative shocks so far this year from the public finances. Favourable revisions recently have resulted in the deficit profile falling broadly into line with the OBR's Spring Forecasts (SF) (Chart 19), and the current budget deficit (the metric used in the fiscal mandate) averaging £1.7bn per month less than last year. Also, the SF implied that the primary fiscal rule and the debt rule were on course to be met by £24bn & £27bn, respectively.

Chart 19: Current budget deficit and PSNBx are now more or less in line with OBR forecasts*

Source: ONS, Macrobond and Investec Economics:

Expressed in CPI terms, we predict inflation to peak at 4% and then fall to sub-2% from Q3 ’27 in our baseline case. Note that the backwardation in oil & gas futures also seems to embed a prompt end to the war. Considering the weakening in the jobs market, signs of which are mounting, we still judge that, rather than hiking, the BoE may merely postpone cutting the Bank rate until ‘27. But risks lie to the upside. In an alternative scenario where the Strait of Hormuz blockades persist long enough to bring about a pinch point when the cushion of inventory drawdown of oil is exhausted, we illustratively calculate a peak in inflation of over 4.5% (Chart 20). If the probability of such an outcome rises, the MPC might well prefer to raise rates.

Chart 20: The peak in inflation is yet to come, but where that lies depends on the Iran conflict

Source: ONS, Macrobond and Investec Economics:

This though is not the only focus for UK markets. Domestic politics has moved into the foreground again as the dismal outcome for Labour in the local elections earlier this month has, not unexpectedly, put pressure on Starmer to relinquish his post as PM to another Labour politician. He has so far resisted. The challenger most likely to beat him in any leadership contest is Andy Burnham. But to be in the running, Burnham first needs to win the by-election in Makerfield on 18 June to re-enter parliament, which is by no means a given. If his bid fails, Starmer could therefore either stay in office or be replaced by Wes Streeting, who is seen as a relative centrist. 

Chart 21: Labour lost a lot of support in the ’26 local elections versus the ’24 General Election

Source: Rallings & Thrasher, Sky News, Investec Economics

By contrast, Andy Burnham is among the more left-leaning Labour politicians. The markets’ worry had been that, to boost Labour’s popularity with the public, a PM Burnham might embark on a fiscal spending spree funded by extra borrowing. At a time when fiscal metrics are much weaker than in recent decades (Chart 22), visibly higher interest rates might be needed to absorb additional debt issuance. This concern manifested itself in gilt market underperformance at a time when interest rates have been rising across the board in other markets too. To reassure markets, Burnham has committed to follow the current fiscal rules, which were last tweaked by Rachel Reeves. These have two key components: the current budget (PSNB ex-investment) should be in…. 

Chart 22: The UK’s public sector debt has risen materially and deficits are still high

Source: ONS, Macrobond and Investec Economics:

…surplus and public debt* as a share of GDP should be falling by the target year. This is currently FY’29/30, but that is a rolling target; it will be the third year of the OBR’s projections from now on. Just how tough a constraint these fiscal rules are is questionable: there is scope for claiming that hard choices will be made in future, even when it is clear these are politically undeliverable. But markets would likely punish gaming the rules, so Burnham’s promises have helped to ease jitters, at least somewhat (Chart 23). Still, amid the trend rise in yields, the first questions are being asked whether active gilt sales by the BoE to shrink the balance sheet into a falling market remain appropriate. Come the autumn, this may be a live issue again.

Chart 23: UK 10y bonds’ underperformance since the start of the war has eased a little lately

*Defined as Public Sector Net Financial Liabilities                                     Source: Macrobond and Investec Economics

The Iran conflict and UK politics have made a mark on sterling. That said, the year-to-date range of GBP’s trade-weighted FX rate has been fairly narrow, at 2.1%; at the same time last year, the range was 4.3%. That GBP has been more stable comes not least as other countries’ money markets have re-evaluated rate expectations in light of the Iran conflict too, and as a poor election outcome for Labour came as little surprise given polls. We forecast mild GBP gains from here, to $1.37 and $1.38 by end-’26 and end-’27 respectively. Against EUR we predict levels of 88p at each horizon as we see more downside risks to UK than to EUR policy rates this year than priced in.

Chart 24: If the BoE does not hike rates this year, this could cap GBP’s performance 

Source: Macrobond, Investec Economics