In the first of two videos to take us into the new year, I look back at some lessons investors should take from 2025. Now, let’s discuss our outlook for the year ahead.
The global economy remains resilient, with indicators pointing to modest but improving growth in the US. Growth may slow early in 2026 as tariffs push inflation higher, squeezing household spending, but this should be short-lived. Our recession risk model has fallen, and we estimate the chance of a US recession at about one in five. Wealth effects are supporting spending while AI investment keeps business activity robust.
The eurozone shows clear improvement, powered by pent-up demand, fiscal support, and deregulation. China’s slowdown persists, with property market stress still evident.
Inflation trends vary by region. In the UK, headline inflation has peaked, and we expect it to fall further, though a return to 2% by late 2026 is unlikely. Persistent pressures from food and services mean it is more likely to settle around 2.5% to 3% next year. The US faces underlying rates closer to 3%. Tariffs and wage pressures are contributing to this persistence but are likely to fade in the second half of the year. In contrast, eurozone inflation is back near the European Central Bank’s 2% target, with few signs of renewed upward pressure.
Interest rate policy reflects these trends. The Bank of England has paused rate cuts for now, balancing concerns about sticky inflation and signs of economic slack, although we expect one or two more cuts. The Federal Reserve has resumed gradual rate cuts, but there is a growing debate about upside inflation risks. The ECB is expected to keep rates low given inflation is near target.
Now, that’s the macroeconomic context. What about the outlook for your investments? In the rest of this video, I’m going to present our base case as well as the bull and bear cases either side of it. Then I’ll come on to how we’re monitoring for so-called bubble risks.
In our base case, equities are set to benefit from continued monetary easing and robust earnings growth, especially in technology and rate-sensitive sectors. While valuations are stretched, the outlook remains constructive if recession risks are avoided. Stable energy prices, increasing willingness for banks to lend, tight credit spreads, diminishing tariff uncertainty, expansive fiscal support, and rising household wealth add to this base case.
Our base case is pretty positive, but supercharged returns could occur in our bull case if European growth comes roaring back, joining stronger US growth from additional investment in AI and consumer spending. In this scenario, wage growth would likely be higher, and the Federal Reserve won’t keep cutting rates. But this won’t matter to equity markets—at least at first—as extra profits come through. More upside could come if China’s economy turns the corner, especially if the US and China reach a trade deal that removes supply chain pressures on small and medium-sized US enterprises and helps China’s exporters as well. Market returns could also be turbocharged if the equity market turns into a bubble—more on that in a moment.
A bear case could occur if we see another wave of tariffs or if American job creation, which has been lackluster recently, gives way to job losses. The current dynamic of low job growth and ongoing cost-of-living problems, but with relatively robust growth overall, is inherently an unstable equilibrium. Either job growth recovers or the whole economy descends into recession. We’re keeping a close eye on the growth-inflation mix and monitoring various leading indicators of activity. A burst of loan delinquencies could be where this shows up first. Another bearish risk, of course, is if investors decide the billions being spent on AI aren’t going to generate enough of a return, at least in the medium term. We’ve been flagging this risk all year. This could parlay into a fall in household consumption as household wealth falls, although we note that household consumption didn’t contract even for a single quarter when the dotcom bubble burst in the early 2000s. It was a crunch in business investment that took the economy into recession back then.
As I explained in our September and November videos, our analysis does not suggest we are in an equity bubble. That does not preclude the possibility of a large fall in equity markets as described in our bear case, but it would be one highly likely to recover. Of course, quite a few investors disagree with us, saying there is a bubble, and they are moving out of US stocks. In many cases, we think this is a narrative-driven, not a data-driven, decision. Classic bubble stories don’t help investors. For decision-useful analysis, we need to identify irrational price increases that imply a predictable strong decline in future prices—and that’s paraphrasing Eugene Fama’s Nobel lecture.
We can identify numerous features of price run-ups that predict a heightened risk of a crash, but crucially, most of these do not predict a heightened risk of poor returns over the following two years. In other words, they don’t tell us anything precise about the timing of the crash. Markets can rise strongly before that crash occurs, making the investor worse off by selling too early, even if a crash eventually occurs. This corresponds with a much more simple statistical description of equity markets since World War II: if we divide bull runs into tenths, the very strongest returns come in the first and last innings. Investors must bear this in mind when establishing their response framework to potential bubbles.
Our framework is evidence-led. Our asset allocation process already has various back-tested signals that indicate when investors should add or lighten equity exposure, such as changes in profit expectations or how other investors are positioned. We’ve supplemented them now with additional conditions carefully drawn from papers published on equity bubbles in finance journals and our own empirical work. They include a set of conditions associated with extreme capital market activity of past equity bubbles, which I spoke about in the November video, as well as growth in the volume of equity options being traded—in short, monitoring for weird and overenthusiastic behavior. That’s not where we are today.
We have a set of conditions associated with the peak of the dotcom bubble: extreme stock performance of firms with no profitability or firms that haven’t been around very long. You see that in other bubbles beyond the dotcom era as well. We are also monitoring for a sharp rise in corporate debt issuance. There is extensive literature demonstrating a link between debt and financial market instability, including a paper published this year on the specific connection between credit growth and subsequent poor equity performance. But as I explained last time, the private sector has been deleveraging over the last few years.
We are also monitoring for early warning signals throughout the AI and data center supply chains that capital expenditure is going to start to get cut, which would likely herald a turn in investor confidence and a drop in equity valuations. We’re using AI to help us with this. We also use AI to construct a basket of 169 companies most aligned to the AI theme to monitor subtle changes in confidence. Importantly, this basket tells us that the average valuation is nowhere near as lofty as you normally see among companies leading bubbles in the past, and their high profitability stands in stark contrast too.
The irony isn’t lost on us that we’re using AI to monitor the risk of an AI crash, but that reminds us of an important point: all of this investment could be socially useful, but that doesn’t mean investors are paying the right price for it.
In sum, we don’t see evidence of a bubble in public equities today. We believe we have developed a robust approach to monitoring for decision-useful information that will tell us to cut exposure to AI stocks whether a bubble forms or not. Furthermore, we know which of our investments are most correlated with the AI trade and have prepared playbooks to help us react with speed if that day comes.
Thanks very much for listening to me present our investment case for next year. We are positive. We think the likelihood of a meltdown is no more likely than the risk of a melt-up. That’s important to note when considering positioning. We stand ready to act with evidence-led decision-making frameworks if a bubble forms. That’s what we mean by investing well. And finally, remember how well investors have been rewarded for patience, due process, and diversification over the last five years through so much uncertainty.
I’m Edward Smith, Co-Chief Investment Officer of Rathbones Investment Management. I look forward to seeing you all next year.
