Global Views: Renewed Escalation vs. Lower Inflation

1. The renewed escalation in the Middle East has pushed oil prices back up, with the Brent futures path above our forecasts of $80/barrel in 2026Q4 and $75/barrel in 2027. The risks to these forecasts are two-sided but on net tilted upward. The swift recovery in flows prior to the most recent escalation shows that Gulf exports can rebound quickly when given a chance, which means that prices could fall sharply if the latest escalation subsides. But more attacks on tankers and Middle East infrastructure could push prices back to the $100+ range that prevailed for much of the hot phase of the conflict.

2. We estimate that the US economy has grown at a trend-like 2¼% pace in H1, as lower taxes on households and businesses have offset the impact of higher gas prices on the consumer. However, H2 is likely to look softer because we still expect a slowdown in real disposable cash flow to weigh on consumer spending, especially if gas prices stay high. One additional downside risk is a slowdown in the AI boom, not so much because of the direct effects on US GDP growth (which are relatively small) but because of the nearly ½pp contribution from the equity wealth effect to consumer spending growth.

3. The weaker-than-expected June employment report has brought our estimate of underlying US job growth down to 73k, from 130k a month earlier. And while we would not ignore a move in the unemployment rate given its proven value as a cyclical indicator, we expect the latest drop to 4.2% to reverse in coming months because it was driven by a suspiciously large drop in labor force participation. Moreover, other signals such as the ongoing weakness in household job market assessments as well as depressed flows both into and out of employment still suggest that the labor market remains a tad cooler than normal. This chimes with the slowdown in our GS wage tracker to 3.4%, below the 4% pace that would be consistent with a 2% inflation target assuming a 2% productivity trend.

4. The US inflation news has improved. We estimate that core PCE rose a benign 0.18% month-on-month and 3.3% year-on-year in June, with other measures such as core CPI (-0.02%/2.6%) and trimmed-mean PCE (0.14%/2.3%) running lower. Moreover, changes to the measurement of prices for software and accessories, portfolio management, and legal services are likely to subtract a net 0.2pp from the year-on-year rate in September. (Even with these changes, the contribution from software and accessories remains overstated because these categories are not quality-adjusted and their weight in core PCE looks excessive relative to either core CPI or price indices in other countries. The BEA’s continued practice of measuring portfolio management fees in terms of dollars rather than basis points—which creates a direct link with equity prices—is arguably also a source of overstatement.) We expect year-on-year core PCE inflation to slow to near 2% in 2027, driven largely by reduced contributions from software and accessories, energy pass-through, and tariff pass-through.

5. Amidst the higher US core PCE numbers this year, it is worth noting how favorable the inflation news has been almost everywhere else. Core inflation in the G10 ex-US—using either the traditional ex food and energy definition or trimmed-mean measures—has continued to trend down this year and now stands at 2.1%, despite the energy price surge in March and April. This means US core PCE is an outlier to the high side, not just relative to alternative measures of underlying US inflation such as core CPI or trimmed-mean PCE but also relative to other economies with similar levels of resource utilization. This reinforces our view that core PCE overstates true underlying inflation, in part because of mismeasurement and in part because of idiosyncratic US shocks such as tariffs.

6. The better inflation news has effectively extinguished whatever chance there was of a rate hike at the July 28-29 FOMC meeting. Hikes at subsequent meetings are possible but would probably require significantly higher inflation and/or lower unemployment than we expect. The broader question is how the FOMC will steer market expectations whenever policy does need to be adjusted in either direction, especially if there is no longer a dot plot (or the move comes at an off-cycle meeting). To keep control of the narrative and prevent financial conditions from overshooting, we think Chairman Warsh will have little choice but to explain the committee’s economic outlook and reaction function in much greater detail than in his first press conference and congressional testimony.

7. The rebound in energy prices probably won’t cause the ECB to hike on July 23, but it has made us more confident in our call for a second hike in September. Beyond that, however, our views diverge from market pricing as we expect the Governing Council to hold off on additional hikes (and return the deposit rate to 2% in 2027). Across the Channel, we are even further below market pricing as we expect no BoE hikes this year followed by three 25bp cuts in 2027. This assumes that incoming Prime Minister Burnham will make good on his promise to stick to the fiscal rules despite tight constraints resulting from the tax pledges in the Labour Party’s manifesto as well as upward pressure on departmental day-to-day spending relative to current plans.

8. The lower-than-expected 4.3% Q2 GDP print confirms that growth in China has slowed this year. Underneath the headlines, activity remains highly bifurcated, with strength in export volumes and industrial production but continued weakness in import volumes, housing, and consumer spending. We expect policymakers to step up their easing rhetoric in the July Politburo meeting and draw on remaining fiscal buffers quickly to stabilize investment and growth. But our full-year 2026 growth estimate has drifted down to 4.6% and the dependence on exports means that China is vulnerable to any renewed global growth shocks from the Middle East or elsewhere.

9. Although the equal-weight S&P 500 has made new highs amidst a strong start to the Q2 earnings season, a pullback in the AI trade and Middle East escalation have weighed on most cap-weighted indices. While our economic view of AI remains optimistic, we think markets are now ahead of the macro from a valuation perspective. Our equity strategists therefore recommend three themes—1) firms delivering consumer experiences, 2) firms with unusually strong sustained earnings growth, ROE and balance sheets, and 3) M&A candidates—to ride out the near-term risks. Our rates strategists think markets price too much tightening but don’t see this changing as long as Middle East escalation risks remain top of mind. Our currency strategists view the current environment as favorable for carry strategies but also expect the CNY to continue appreciating. Our credit strategists continue to expect some modest widening in spreads, due in part to the wave of AI-related debt issuance that will need to be absorbed across a range of markets. And beyond energy, our commodity strategists argue that the recent reacceleration in central bank purchases should help gold prices rebound, although they acknowledge the near-term risks from energy and rates markets.