From oil prices and inflation to interest rates and AI, we explore the forces shaping the global economy and what they could mean for investors.
World Economy shows resilience, but can it last?
At the recent IMF meeting in Bangkok, there was widespread agreement that the world economy had proved to be more resilient than expected in the face of the significant oil shock which followed the outbreak of the US-Israeli war with Iran. In the past, oil shocks of this magnitude have de-railed activity and plunged the world economy into a period of weak activity, if not recession. The continued resilience of activity this time around has surprised many and helped support growth in stock markets, which until the recent turmoil after the US elections have continued to hold up. The question now is how long can the economic resilience last, particularly given a further rise in bond yields and the elevated oil price.
Alternative sources of oil supply and spending on the AI roll out have helped
Looking at the picture so far, two factors have been important in keeping growth going.
The first is the flexible supply response following the fall in oil production in the Middle East. Countries were able to find alternative energy suppliers in the face of the closure of the Straits of Hormuz. Those suppliers being primarily from the US, but also Norway, West Africa and Russia. The IMF estimate that this flexible response more than halved the impact of the oil supply shock on global GDP from a 1 percentage point (pp) hit to 0.4 pp.
Such flexibility comes on top of the long term trend which has reduced the world’s dependence on oil from 47% of global energy consumption in 1970 to 33% in 2025. The IMF believe this reduced the effect in the current crisis by a further 0.1 pp of global GDP. The latest episode will only accelerate the trend by encouraging more consumers to make the switch.
The second factor is spending on the roll out of Artificial Intelligence (AI) which continues apace as the large tech firms, known as the hyperscalers, race to develop their models and secure the semi-conductor chips needed to run them in the future. Such spending is increasing demand for chips, hardware, software and power and has added between 0.6% and 1% to US GDP growth over the past year. The effect elsewhere is smaller, but has been substantial in Asia as semi-conductor chip production has soared. There has been little discernible impact on European growth, although some of the surprise in the UK’s recent GDP performance does seem to be related to an increase in computer programming activity, no doubt linked to AI.
The AI roll out shows no sign of fatigue
Looking ahead, the latest business surveys show no let-up in the great AI roll out with the purchasing managers surveys signalling more growth in coming months. Economic activity and corporate earnings growth have been strong as a result helping to offset the drag from higher energy prices and inflation. The strength of profits growth has been key in driving equity markets with the US tech sector leading the way. However, as noted in our Mivida summer report, investors are still questioning how profitable the AI industry will be in future given the huge capital sums being deployed. Investors are also now more concerned about future regulation on AI firms given the shift in control in Congress.
Oil inventory levels have been run down and are becoming thin
On the energy side, unless there is a swift resolution of the US-Iran war it is hard to be optimistic. The flexibility in oil supply has been brought about not just through finding alternative suppliers, but by running down the inventory of oil by releasing strategic and commercial reserves into the market. Fortunately, the world started this process with relatively high inventory levels, however the rapid drawdown has taken stocks to levels which are described by the International Energy Agency (IEA) as thin.
This suggests that unless more supply is found or demand falls there will be shortages in 2027. Despite President Trump’s efforts, the Straits of Hormuz remains effectively closed and the spread of the conflict means that Saudi Arabian production is also now being disrupted. The likelihood is that oil prices will remain around $100/ barrel for the foreseeable future.
Oil prices set to remain high, keeping pressure on inflation
The prospect of elevated oil prices means little respite from higher inflation, keeping pressure on central banks to tighten monetary policy. The Bank of England, which has been sounding increasingly hawkish, hiked bank rate on 5 November to 4%, the first increase since 2023. The US Federal Reserve, which hiked in September is widely expected to raise again when it meets in early December. The European Central Bank has also tightened further and raised interest rates to 2.5% in September.
Bond markets anticipate further rate hikes
Such moves have come as little surprise to bond markets which have priced in further hikes into 2027. The rise in bond yields has largely been a consequence of the deterioration in inflation prospects and acts as a further brake on activity through higher borrowing costs. These are being felt in the housing market as fixed rate mortgage rates rise and, of course, by governments who now find interest payments one of their largest outgoings.
Government borrowing costs also reflect the increase in budget deficits. France has been the focus of attention in recent weeks as the French Parliament has been incapable of agreeing a budget. With riots on the streets it is unlikely that there will be an early solution. Meanwhile, French yields and spreads continue to widen as markets press for action.
The UK government may be relieved that the attention is elsewhere, nonetheless the effect of higher gilt yields was felt in the recent budget where the Chancellor saw his fiscal headroom cut from £24bn to £12bn as a result of higher borrowing costs. By assuming this was a temporary cost of war, he has avoided taking action to rebuild the buffer, but there are limits as to how much more of a rise in rates can be sustained before fiscal policy has to respond.
Chancellor Healy’s budget ducked the key issues and raised speculation of a 2027 election
Overall the budget lacked any strategic effort to tackle the big fiscal issues on controlling spending on welfare benefits and pensions, whilst continuing to fund the NHS and raise defence spending. The projected fall in the budget deficit assumes the government will make severe cuts in public spending in two to three years time, which seems implausible given the electoral cycle. At the personal level the chancellor did not address the numerous cliff edges in the system, such as when working families are heavily penalised for earning over £100k and has left the tax code far more complex. Not surprisingly, speculation is now rife that PM Burnham is looking for an early general election.
How should investors respond?
From a market perspective, the prospect of a challenging year ahead where the world economy proves less resilient suggests an element of caution. Strategists are reluctant to reduce equity exposure, but rebalancing and diversification amongst equity markets and styles seems sensible. Bond investors are rightly wary of further sell offs unless governments show a greater willingness to contain deficits and debt. However, there is value in current yields which exceed growth rates in some major economies indicating that future returns will compare more favourably against equities than in the past.
Keith Wade
Former Chief Economist, Schroders
Adviser to the Mivida Investment Committee
