Mid-year economic outlook 2025-26; Global boiling – Heatwave may cost -0.5pp of GDP in Europe
Ludovic Subran
Group Chief Investment Officer at Allianz, Senior Fellow at Harvard University
Under pressure: From geopolitical tensions to economic fragmentation, from great power rivalries and disrupted supply chains to climate stress and institutional fatigue, the world is operating under sustained stress. Some see this as a warning sign of deeper systemic cracks. While pressure can lead to transformation, even progress, stress alone doesn't guarantee clarity or resilience—it often just reveals fragility. As we reach the halfway mark of 2025, the global economy remains under pressure, signaling a challenging road ahead. Our updated forecast paints a picture of sluggish growth and persistent uncertainty, the detailed picture in our publication & the related slide deck.
Nature under pressure, too. A recent report by Allianz just aired on why a thriving planet maters for us all. And the heat is on, literally: In this week’s What to watch section, we investigate the global heat surge and analyze the economic implications across Europe. After all: A diamond is just a piece of coal that did well under pressure.
Mid-year economic outlook 2025-26
Summertime sadness
“Under Pressure”: Global growth will remain sluggish at +2.5% in 2025, the slowest since 2008 outside of recession periods. The US forecast has been upgraded by +0.8pp to +1.6% in 2025-26 due to the lower effective tariffs. The Eurozone should see growth at +1.2%, largely driven by smaller economies, while Germany is projected to see +1% growth only in 2026 after +0.1% in 2025. Emerging markets show mixed results, some benefiting from FX appreciation and increased investment flows, with currency gains averaging 10% year-to-date. Trade forecasts for 2025 suggest a slight improvement: Global trade in goods is expected to grow by +0.3% (and global trade of goods and services +1%), driven by continued frontloading and rerouting, though 2026 remains subdued with projected growth of +1.2% due to persistent uncertainties.
Trade tensions, geopolitical risks and fiscal challenges could “Rock the Boat”. The path to our US tariff baseline scenario proved to be more rapid, but global uncertainty continues to prevail at record-high levels. This will lead to a synchronized decline in the economic cycle in both developed and emerging markets, last seen in the second half of 2022 during peak inflation. Since our last Economic Outlook on 10 April, the US global import tariff rate has been lowered from 25% to 13% as the trade truce with China brought the US bilateral tariff rate down from 103% to 39%, contributing more to the downside than the higher sectorial tariffs (auto and auto parts at 25%, steel and aluminum at 50%). However, the US global import tariff is still at the highest level since 1940, and looming threats include potential additional tariffs of +50pps on the EU and reciprocal tariff deadlines on 8 July. Sector investigations also continue, with possible additional tariffs on automotive products (incl. trucks), copper, lumber, pharmaceuticals, commercial aircraft, jet engines and parts and critical and processed minerals. Beyond the trade war, the US faces significant fiscal and monetary challenges, with the fiscal deficit projected to exceed 8% of GDP by 2026 and interest payments increasing due to high inflation and fiscal risks, which could lead to nervous bond markets and further USD depreciation. The probability of a recession exceeds 30% and there are rising concerns over stagflation. In Europe, defense spending surpasses the 3.5% of GDP threshold required by the US in most NATO members, but capacity bottlenecks and reliance on debt financing will continue to exert upside pressures on long-term rates. Geopolitical strife, particularly in the Middle East, keeps uncertainty high. While the conflict has pushed oil prices up over 20%, the economic fallout will be limited unless escalation leads to pivotal disruptions, such as a Strait of Hormuz closure, which could see prices spiking to 120 USD/bbl.
When it comes to interest rates, the Fed will be "(Sittin' on) The Dock of the Bay" while the ECB will "Drop It Like It's Hot". Central banks are taking divergent approaches, with the US Federal Reserve maintaining rates at 4.5% until December amid inflation concerns, set to peak at 3.9% by Q4 2025. The Fed is expected to cut rates to 3.5% by Q3 2026. In contrast, the ECB will continue its easing cycle amid low growth and disinflation, cutting rates to 1.5% by year-end. In emerging markets, 32 large economies that account for more than 35% of global GDP will be easing monetary policy in the second half of 2025, supported by ongoing FX appreciation and receding inflation; 23 of them will continue easing well into 2026. We identify four clusters: (i) those boldly leading the trend with an ambitious rate-cut path by end-2026, often coming from double-digit inflation (Mexico, Hungary, Argentina, Türkiye) but at risk of stalling should oil prices rise further and/or FX depreciation accelerate; (ii) those that were initially bolder but are less so now as inflation emerges again (Czechia, Kenya); (iii) laggards that will move ahead of the Fed (Poland, Romania), thanks to FX appreciation and moderating growth leading to back-to-target inflation and (iv) those that will pursue moderate rate cuts (China, South Africa, Morocco, India, Indonesia, Philippines, Thailand, Taiwan, Malaysia, Vietnam) as they approach the end of their easing cycles and balance inflation, growth and currency risks. Brazil remains the EM exception, continuing its own soon to-end hiking cycle to fight inflation.
It’s a “Cruel Summer” for corporates, which are optimizing inventories and adjusting pricing strategies to maintain profitability amidst sluggish demand. The labor market shows signs of normalization, with layoffs expected as companies focus on efficiency and cost-cutting. Investment growth remains timid, particularly in Europe, where credit conditions are improving but constrained. Loan growth stands at only +2% despite a 200bps reduction in ECB rates. Insolvency trends also present additional risks, with the global index indicating a +6.5% increase in Q1 2025. In addition, sector-specific risks are emerging, particularly in the automotive industry, due to competitive pressures and technological shifts. The construction sector in the US is under scrutiny due to profitability squeezes from rising wage pressures and immigration cuts, which exacerbate labor shortages and could lead to project delays and payment issues. Meanwhile, the pharmaceutical sector is on a negative watch list due to potential regulatory changes and cost pressures.
But capital markets are “Walking on Sunshine” despite geopolitical woes. Risk markets, especially equities, staged a rapid recovery following the challenges of “Liberation Day”. We are revising our forecast to reflect these positive developments, taking the catch-up phase into account but without significant further outperformance for the remainder of the year. This trajectory would still leave European equity markets up +18% year-to-date. Interest rates are expected to stabilize around current levels but will remain volatile, influenced by ongoing geopolitical developments. Despite a recent significant depreciation, we do not foresee a prolonged weakening of the USD, supported by real interest rate differentials and barring news triggering substantial capital outflows from the US. The removal of Section 899 from the latest US tax bill reinforces this outlook.
What to Watch this week
Global boiling – Heatwave may cost -0.5pp of GDP in Europe
The ‘hot’ story for you here.
An initial ‘back of the envelope’ calculation suggests that the recent heatwaves across Southern and Central Europe, the US and China could carry significant economic costs. Estimated GDP losses range from -0.1pp for Germany to as much as -1.4pp for Spain, with total losses of -0.5pp for Europe, -0.6pp for the US and -1.0pp for China. To put this into perspective, one day of extreme heat (above 32°C) is equivalent to half a day of strikes. At least heatwaves have only temporary effects on production and a partial recovery in manufacturing and services is likely, while losses in agriculture and certain infrastructure sectors tend to persist.
Adaptation is key. In the short term, warning and prevention measures can be put in place. But these need to be complemented by longer-term structural adaptation measures to prepare cities for climate change (i.e., urban greening) and ways to productively adapt workplaces to an increased heat burden (i.e., adapting buildings, infrastructure and working hours).
The ‘hot’ story for you here.