Financial markets face significant upside and downside risks as summer ends.

First, the global economy has proved resilient despite the shocks of US trade wars and the wars in the Middle East. We expect the US will suffer stagflation as steep tariffs are a supply shock to its economy. US growth has slowed sharply this year and core inflation has rebounded near 3%. But activity in the Eurozone, UK, China and Japan has been stronger than expected.

Second, major central banks have continued to cut interest rates. The European Central Bank (ECB), the People’s Bank of China (PBoC), the Bank of England (BoE) and the Swiss National Bank (SNB) have lowered interest rates to 2.00%, 1.40%, 4.00% and 0.00% respectively.

Third, financial conditions have loosened with the Fed set to resume rate cuts. US Treasury (UST) yields have fallen, and the US Dollar has stayed weak.

Given the weak US labour market data recently and dovish comments from US Federal Reserve (Fed) Chairman Jerome Powell at Jackson Hole last month, we see three Fed rate cuts occurring this year - in September, October and December.

Resilient activity, falling interest rates and lower UST yields have been important tailwinds for risk assets this year. But investors need to be aware of downside risks to the economic outlook.

Steep US tariffs are set to slow global growth in the second half of 2025. Inflation is proving sticky, making it unlikely the ECB will cut rates anymore. And the Trump administration’s campaign to curb Fed independence may have immense long-term implications including higher inflation, steeper yields and a much weaker US Dollar.

Investors should thus continue to maintain diversified, resilient portfolios given the upside and downside risks to the outlook this year.

US – The Fed is leaning towards resuming rate cuts

The US August employment report was weak again, cementing the case for the Fed to cut its Fed funds rate by 25 basis points (bps) from 4.25-4.50% at the next Federal Open Market Committee (FOMC) meeting on September 16-17.

Last month payrolls only rose 22,000. Prior data was also revised to show June’s fell 13,000, the first monthly decline since the pandemic in 2020. Payrolls have only increased by 27,000 on average over the last four months, a clear step down from the average gains of 123,000 in the first four months of 2025 and 168,000 in 2024.

At the same time, unemployment also rose from 4.24% to 4.32%, still low historically but likely reflecting falling demand for labour. In contrast, labour force participation edged up from 62.2% to 62.3% as the supply of labour firmed in August.

With Powell indicating at Jackson Hole last month that the Fed would cut interest rates if the US labour market kept slowing, we bring forward our view of one 25bps cut in 2025 and two in 2026 to all three cuts occurring this year now in September, October and December. We thus see the Fed funds rate ending 2025 at 3.50-3.75%.

For 2026, a new Fed Chair will lead June’s FOMC meeting. We do not rule out further rate cuts from next summer if President Trump’s candidate is dovish. It is not our base case as inflation is set to stay sticky but is clearly a risk to the outlook.

China – A game of two halves this year for GDP growth

China’s economy was surprisingly resilient in the first half of 2025 as exporters’ frontloading to beat US tariffs caused GDP to grow solidly above 5.0% year-on-year (YoY) in 1Q25 and 2Q25. In contrast, the second half of the year has started much slower with July’s activity data all missing forecasts as subdued consumers, cautious companies, a weak property market and higher trade barriers curb demand.

First, new loans for households and corporates have contracted for the first time since 2005 as families and firms remain cautious after the pandemic. Second, July’s retail sales slowed from a 4.8% YoY growth to 3.7% YoY as consumers seemed reluctant to spend despite official subsidy schemes. Third, fixed asset investment in July declined to just 1.6% YoY, its weakest rate since the height of the pandemic in 2020.

The slowdown in activity should not be surprising given the economy’s strong first half. We expect full year GDP to only dip from 5.0% in 2024 to 4.6% in 2025. But July’s data shows overall demand remains lacklustre, keeping GDP growth subdued.

We continue to think stronger broad-based growth to lift the economy away from deflation will require fresh fiscal stimulus. Beijing may not act while growth is still only slowing. But China’s financial markets are likely to stay supported as investors expect officials will provide more stimulus in future if growth slides more rapidly.

Europe – Rate cuts are ending as growth stays resilient

This year, European growth has been surprisingly resilient in the face of much higher US tariffs. The ECB has reduced interest rates from 4.00% last year to 2.00% and the BoE has cut its Bank Rate from 5.25% in 2024 to 4.00% now, helping support activity. But with Eurozone inflation back at the ECB’s 2% target, we expect the ECB will not make any more rate cuts now.

In the UK, inflation has rebounded uncomfortably to 3.8%. The BOE forecasts inflation to peak well above its 2% target before falling as the labour market slows. The BOE has cut interest rates gradually by 25bps each quarter since August 2024.

We expect the BOE to ease once more in November by 25bps, but with four out of nine of its policymakers already voting against further cuts, we think the BOE’s easing cycle is close to ending with its Bank Rate likely to settle at 3.75%.

Japan – Very gradual interest rate hikes are set to restart

Like the UK, inflation in Japan remains well above the Bank of Japan’s (BOJ) 2% target with core inflation, excluding fresh food and energy costs, at 3.4%. The very weak Japanese Yen (JPY) which is near 150 against the US Dollar (at the time this was written), is driving import costs higher and keeping goods inflation elevated at 4.5%. In contrast, services inflation remains much lower at 1.5%.

Moderate services costs have allowed the BOJ to only slowly lift interest rates from -0.10% in March 2024 to 0.50% now. But with a new US-Japan trade deal signed and core inflation over 2% for three years now, we expect the BOJ will resume rate hikes in October with a 25bps increase to 0.75%.

Importantly. the resumption of very gradual rate hikes in Japan, once every six months or so, while the Fed prepares to resume rate cuts, will allow the JPY to start rebounding from its current low levels against the USD.