Energy shocks test resilience as policy paths diverge

Key points

• Middle East tensions and higher oil and gas prices are weighing on global growth and pushing inflation forecasts higher, with Europe, the UK and Japan particularly exposed due to energy dependence.

• The US retains a relatively constructive growth outlook, underpinned by resilient demand and policy support. 

• Central banks have turned cautious and are responding unevenly to the inflation–growth trade‑off.

United States

Constructive momentum amid inflation and uncertainty

The US economic outlook remains constructive, supported by continued strength in business investment and generally resilient household demand. That said, recent developments have led us to modestly recalibrate our expectations. We have downgraded our 2026 real GDP growth forecast by 0.2 percentage points to 2.3%, reflecting firmer energy prices and emerging tariff pass‑through effects.

We continue to view the labour market as fundamentally resilient, albeit transitioning towards a slower growth phase, and we have thus revised our year‑end 2026 unemployment rate forecast to 4.6% from 4.2%. Heavily concentrated job creation in health care continues to reflect structural demand in health care services, a trend we expect to persist over the coming years.

Inflation has resumed its uneven deceleration, though at a slower pace than previously anticipated. We have revised our year‑end 2026 core inflation forecast up by 0.2 percentage points, driven by renewed firmness in non‑housing services, incremental tariff pass‑through and higher energy prices amid escalating geopolitical tensions involving Iran. 

Against this backdrop, we assess monetary policy to be near neutral. While we retain our expectation for a single policy rate cut in 2026 - consistent with the US Federal Reserve’s willingness to look through energy‑driven price shocks - the principal risk has shifted toward a longer period of policy inertia, particularly if labour market cooling remains gradual and inflation progress proves uneven.

United States economic forecasts

Notes: GDP growth is defined as the fourth-quarter-over-fourth-quarter change in real (inflation-adjusted) GDP in the forecast year compared with the previous year. Unemployment rate is as of December 2026. Core inflation is the year-over-year percentage change in the Personal Consumption Expenditures price index, excluding volatile food and energy prices, as of December 2026. Monetary policy is the rounded midpoint of the Federal Reserve’s target range for the federal funds rate at year-end.

Source: Vanguard.

United Kingdom

Stagflation a key risk amid Middle East conflict

The impact of heightened tensions in the Middle East on the UK outlook will depend on the magnitude and persistence of the energy shock and the policy response. Elevated uncertainty and financial market volatility leave the outlook highly sensitive to developments in energy prices and inflation expectations.

We have revised our policy outlook and now expect the Bank of England (BoE) to maintain its bank rate at 3.75% rather than make two cuts in 2026. While the BoE had previously adopted a more dovish tone, the initial impact of the energy shock has complicated the policy trade‑off. Against this backdrop, policymakers are likely to take a wait-and-see approach until there is greater clarity on the evolution of energy prices and inflation expectations. 

On growth, we have downgraded our 2026 GDP forecast by 0.4 percentage points to 0.6%, based on a scenario in which oil prices average $90–$100 per barrel and gas prices average €60/MWh for one to two quarters. Roughly half of the downgrade reflects the direct drag from higher energy prices, with the remainder driven by tighter financial conditions.

Higher oil and gas prices are expected to elevate inflation in the near term. We have raised our 2026 headline Consumer Prices Index (CPI) forecast by 0.6 percentage points to 2.8% and our core CPI forecast by 0.2 percentage points to 2.8%. The UK is more exposed to energy shocks than the US given its status as a net energy importer, while regulated prices add to inflation persistence, as highlighted during the 2022–23 energy crisis.

United Kingdom economic forecasts

Notes: GDP growth is defined as the annual change in real (inflation-adjusted) GDP in the forecast year compared with the previous year. Unemployment rate is as of December 2026. Core inflation is the year-over-year change in the Consumer Prices Index, excluding volatile food, energy, alcohol and tobacco prices, as of December 2026. Monetary policy is the Bank of England’s bank rate at year-end.

Source: Vanguard.

Euro area

Middle East conflict skews outlook towards rate hikes

The escalation of tensions in the Middle East has led to a renewed surge in oil and natural gas prices, introducing a material downside risk to the euro area outlook. The macroeconomic consequences will hinge on how large and persistent the energy shock proves to be, but uncertainty has risen sharply and confidence indicators have begun to soften.

Under a scenario in which oil prices average $90–$100 per barrel and gas prices average €60/MWh for one to two quarters, we have reduced our 2026 GDP growth forecast by 0.4 percentage points to 0.8%. Most of the downgrade reflects the direct hit to real incomes and production costs from higher energy prices, with a smaller contribution from tighter financial conditions. 

Higher energy prices also have clear implications for the inflation outlook. We have revised our 2026 headline inflation forecast upwards to 2.5%, while lifting core inflation more modestly to 2.1%. The euro area remains particularly sensitive to energy shocks given its reliance on energy imports and the relatively large weight of energy in the inflation basket. Even so, inflation expectations remain broadly anchored, reflecting a more favorable starting point than during previous shocks.

The policy stance of the European Central Bank is on a knife edge and firmly data dependent. We continue to expect policy rates to remain on hold, with the Governing Council attempting to look through an energy‑driven inflation shock.

Euro area economic forecasts

Notes: GDP growth is defined as the annual change in real (inflation-adjusted) GDP in the forecast year compared with the previous year. Unemployment rate is as of December 2026. Core inflation is the year-over-year change in the Harmonised Indexes of Consumer Prices, excluding volatile energy, food, alcohol and tobacco prices, as of December 2026. Monetary policy is the European Central Bank’s deposit facility rate at year-end.

Source: Vanguard.

Japan

BoJ laying the groundwork for gradual rate increases

The Middle East conflict poses the greatest growth headwind for Japan, given its heavy energy dependence. Its sizeable strategic oil reserves (equivalent to around 254 days of consumption) should cushion domestic supply, but a prolonged blockade could prove detrimental. We have downgraded our 2026 GDP growth forecast by 0.2 percentage points to 0.8%. 

Japan’s inflation had been easing because of government price‑relief measures, but they have been partially offset by higher oil prices and a weakened yen, pushing headline CPI higher in the near term.

Meanwhile, Shunto wage negotiations point to a third straight year of roughly 5% hikes, highlighting acute labour shortages and a strengthening wage-price cycle. This has reinforced confidence at the Bank of Japan (BoJ) that underlying inflation will remain close to 2%, with inflation expectations increasingly anchored on the upside.

Amid sustained wage growth, the BoJ is laying the groundwork for a gradual resumption of policy tightening this year. Mindful of yen volatility and energy‑price risks, we expect the BoJ to raise rates twice in 2026, taking the policy rate to 1.25% by year‑end, provided progress towards price stability remains intact. 

Japan economic forecasts

Notes: GDP growth is defined as the annual change in real (inflation-adjusted) GDP in the forecast year compared with the previous year. Unemployment rate is as of December 2026. Core inflation is the year-over-year change in the Consumer Price Index, excluding volatile fresh food prices, as of December 2026. Monetary policy is the Bank of Japan’s year-end target for the overnight rate.

Source: Vanguard.

China

A GDP growth surprise to start 2026

Real GDP growth surprised to the upside in the first quarter, rising 5.0% year over year and materially exceeding expectations. Strength was driven by resilient exports, early fiscal deployment and limited near‑term spillovers from the Middle East conflict. However, we expect momentum to ease in the second quarter as fiscal frontloading unwinds, global demand softens amid the potential for continued energy supply disruptions and uncertainty persists around the durability of property market stabilisation. On balance, we have revised our 2026 growth forecast up to 4.7%, from 4.5%.

The GDP growth reflected an easing of deflationary pressures alongside higher oil prices. We have increased our 2026 core inflation forecast to 1.2%, up from 1%. However, the oil‑driven cost shock is unlikely to generate sustained reflation without a more meaningful recovery in domestic demand. Price pressures remain concentrated upstream, with limited pass‑through to consumer prices amid still‑soft household spending.

The stronger growth momentum reduces the urgency for near‑term rate cuts, and the People’s Bank of China has signaled a preference for targeted and structural measures rather than broad‑based easing. We now expect only a 10‑basis‑point cut this year, which would bring the year‑end policy rate to 1.3%, modestly higher than our prior expectation. 

China economic forecasts

Notes: GDP growth is defined as the annual change in real (inflation-adjusted) GDP in the forecast year compared with the previous year. Unemployment rate is as of December 2026. Core inflation is the year-over-year change in the Consumer Price Index, excluding volatile food and energy prices, as of December 2026. Monetary policy is the People’s Bank of China’s seven-day reverse repo rate at year-end.

Source: Vanguard

Asset-class return outlook

Vanguard has updated its 10-year annualised outlooks for broad asset class returns through the most recent running of the Vanguard Capital Markets Model® (VCMM), based on data as at 31 March 2026.

Our 10-year annualised nominal return projections¹, expressed for local investors in local currencies, are as follows:

¹ The figures are based on a 2-point range around the 50th percentile of the distribution of return outcomes for equities and a 1-point range around the 50th percentile for fixed income.