The year ahead looks set for a more balanced, although not necessarily benign, inflationary backdrop, even as the full impact of the US trade tariffs has yet to materialise in prices. For investors returns are more likely to come from income carry and specific exposure to inflation risk.
2025 was another year defined by tension rather than direction. And that tension was most visible in interest rate markets.
On the surface, the story looked simple – inflation ‘eased’, growth held up better than expected, and central banks cut interest rates. In practice, it was more complicated. Governments continued to spend (or announce more spending), deficits widened, and bond issuance rose along with political uncertainty.
While central bank policy rates were generally lower, longer-term bond yields sold off as term premia rose. Any rally in advanced economy rates was uneven and with frequent and sharp reversals, it provided a fertile terrain for investors looking for market volatility.
Inflation – Fading, but not gone
Inflation refused to quietly fade away. Headline consumer price numbers improved, arguably supported by lower oil prices in an oversupplied market, but they remained well above pre-pandemic levels (see Exhibit 1). Services inflation held firm, labour markets proved somewhat resilient, and pricing power lingered in parts of the economy.
As we had anticipated last year, this backdrop supported inflation-linked bonds. Inflation accrual mattered again, reminding investors that inflation protection is not just about tail risks, but about income in an uncertain world.
Exhibit 1
More balance
For 2026, the outlook appears more balanced, though far from benign. Inflation should continue to move closer to central bank targets, but the idea of a clean return to the low-inflation regime of the 2010s looks increasingly outdated. Instead, the key question is not where inflation will land, but how quickly it gets there and how the normalisation unfolds across regions.
The US stands out for its persistent inflation. Domestic demand has remained strong, and services inflation has been slow to cool. On top of that, the full impact of the import tariffs has yet to show up in prices. Disinflation is likely to continue, but not in a straight line. We can still expect inflation of close to 3% in 2026. For the Federal Reserve, this means caution, even with a new Chair.
Europe tells a different story. We expect inflation to fall more quickly, potentially undershooting the ECB’s target in the first part of the year as the effects from lower oil prices and a stronger euro materialise. Over time, inflation should stabilise at close to 2%. The path there is likely to be smoother than in the US.
The UK goes one step further. Faster normalisation could see inflation end 2026 at below current market expectations, supported by softer economic growth and a potentially weaker labour market.
Growth itself should remain supportive. Beyond artificial intelligence-related investment and wealth effects from the equity market rally, fiscal policy will likely play a central role, particularly in the US and Europe, where public spending should provide a cyclical boost.
This should reduce the risk of a sharp slowdown and gives central banks room to move carefully. However, with real interest rates still restrictive, the bar for renewed rate hikes is set high, even if policymakers stay alert to the upside risks from wage and services inflation.
What does it mean for portfolio allocation?
For investors, this environment calls for a more selective approach. Big directional bets on rates or inflation look less compelling to us when policy paths are likely to diverge across regions. Instead, returns are more likely to come from carry and specific exposure to inflation risk.
This is where inflation-linked bonds continue to earn their place in portfolios. Inflation risk is currently priced at modest levels, while term premia in many markets look attractive. That combination offers an appealing asymmetry:
- If inflation is stickier than expected, inflation-linked bonds can provide protection and resilience
- If inflation continues to normalise, investors should still benefit from lower real yields and diversification.
In our view, the broader lesson of the post-COVID-19 period is that inflation uncertainty has changed, not disappeared. The world has become more fragmented, more fiscal, and more sensitive to political swings. In that context, inflation-linked assets, used thoughtfully, remain a potentially powerful tool for navigating a world where certainty is scarce and where inflation still matters.
