Prolonged volatility ahead for financial markets

Uncertainty on inflation and growth risks for 2026

Well, we’ve made it through one very interesting year: Changes in U.S. tariff policy have upended long-standing global trade norms; fears of stagflation (combined economic stagnation and elevated inflation) have lingered but so far failed to materialize; the longest government shutdown on record has left us without key economic data; and excitement about generative artificial intelligence (GenAI) has spurred financial markets’ enthusiasm to new heights and raised both utopian and dystopian expectations. And these are just the highlights.

What do we make of all this, and what should we expect in 2026 for the economy and markets?

Uncertainty and volatility, in short. But let me be more specific.

I maintain a constructive outlook for U.S. growth. Household consumption has proved resilient, and in the early part of next year will be goosed by a substantial fiscal stimulus, estimated by Brookings at well above one percentage point of gross domestic product growth for the year. Moreover, the Federal Reserve (Fed) has gifted us with a meaningful easing in monetary policy. And the artificial intelligence (AI)-focused investment boom is set to continue. Last but not least, I expect the faster pace of productivity growth that we have enjoyed over the past couple of years should be sustained into 2026 and beyond.

There is a lot of uncertainty, however, and some signs of weakness in both employment and investment. The unemployment rate has crept up, albeit to still low absolute levels, and companies seem reluctant to hire. The quality of labor-market data has gotten very shaky, so it’s hard to gauge the extent of the underlying weakness, but weakness there is. Outside of the AI development boom, companies might still be hesitant to invest, though it might just be taking longer for the carrot of accelerated investment depreciation to translate into new capital expenditure (capex) decisions.

Stagflation risk remains, but it’s just not evenly distributed. I see the balance skewed toward inflation risks, especially in the first part of 2026. That’s when additional fiscal stimulus will likely put more money in consumers’ pockets, and if “tariff rebate checks” actually materialize, they would provide a further boost to purchasing power. This could reignite consumer spending, adding to an extended AI investment boom. A similar dynamic to the post-Covid-19 recovery, though on a smaller scale, which might push inflation toward a 3.50%-4.00% range.

Another jump in the price level, in an environment that could make it harder for wages to catch up, could slow consumer spending somewhat later in the year. Non-AI investment might take longer to accelerate. The extended, remarkable outperformance of AI stocks poses another risk. I believe advances in GenAI will gradually fuel efficiency-enhancing business applications. And the major investments in chips, data centers, and power generation could boost the economy’s growth potential – these are not bridges to nowhere. But the market excitement may have run ahead of what GenAI can deliver in the short term, creating the risk of a temporary market adjustment. If that materializes, it would be an additional headwind for growth, but a temporary one. Overall, I see risks to growth as less pronounced, and my baseline is for economic activity to remain upbeat.

Conversely, I still do not see the conditions for inflation to come back to 2%. The Fed has now cut interest rates by a cumulative 175 basis points (bps), taking the fed funds rate to 3.50%-3.75%. The easing has been excessive, in my mind, but not entirely unreasonable. With inflation stable, albeit still well above target, I can understand the doves’ desire to get ahead of a possible sharper rise in unemployment. The marked division within the Federal Open Market Committee, though, underscores that inflation risks are still alive and kicking. While Fed Chair Jerome Powell has argued that the fed funds rate is still within a reasonable estimate of the neutral rate, a rebound in inflation would quickly turn the real policy rate negative, which would seem inappropriate in an economy running at or above potential.

Even more significant, in my view, is the Fed’s decision to expand the balance sheet anew with purchases of short-term Treasuries. Powell justified this with the need to maintain ample reserves in the banking system. In practice, though, the Fed will keep funding a perennially large government deficit, and fiscal dominance will continue to shape the monetary stance of a central bank already dovish by nature and by institutional memory. A sustained large fiscal deficit aided and abetted by central bank purchases of government bonds won’t help bring inflation down to target.

This persistent and significant uncertainty on both inflation and growth risks implies prolonged volatility in financial markets, in my view. The 10-year U.S. Treasury yield is higher than it was in August 2024, before the Fed started its 175 bps reduction in the policy rate – inflation as measured by the core personal consumption expenditures index is essentially unchanged since then. The corresponding steepening in the yield curve speaks to both confidence in economic growth and underlying concern about the pressures from loose fiscal policy. Developments in unemployment and inflation could keep long-term yields on a moderate roller-coaster ride in 2026, and my baseline has the risks skewed moderately to the upside.

For financial markets, macro is back in the driver’s seat in a way we haven’t seen in some time – Zero Interest Rate Policy is a fond distant memory, carry has its due – and the regime shift is bigger than just rates: a more multipolar geopolitical order, China’s structural slowdown, Japan’s reflation, Europe’s planned defense spending boost, and AI advances, which could extend the productivity renaissance.

Against a constructive (though uneven) growth backdrop, I don’t expect a sharp rise in corporate defaults, but with spreads near record tights and heavy issuance, further tightening looks limited. I think the Fed will be cautious on additional easing – especially if fiscal tailwinds keep inflation sticky – so duration looks unattractive and investors would be wise to stay nimble while harvesting today’s fairly attractive yields.

With the U.S. dollar still historically strong despite 2025’s depreciation, I believe global and emerging market diversification will likely play an increasingly important role in 2026 investment strategies. Finally, with valuations elevated and labor dynamics challenged, U.S. growth looks increasingly levered to AI capex and the equity wealth effect – in my view creating clear winners and losers and making active management critical to navigate volatility and find the best pockets of value.

Sonal Desai, Ph.D. is the executive vice president and Chief Investment Officer for Franklin Templeton Fixed Income at Franklin Templeton. Originally published in the Franklin Templeton Insights page.

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