Financial markets are set to remain volatile in the second half of the year.

The shocks of the first half of 2025 – sweeping US import tariffs, Europe’s drive to re-arm against Russian threats, the Middle East’s violent wars in Gaza, Lebanon, Israel and Iran, and Asia’s deteriorating trade outlook - are unlikely to be the last for the year.

This year, we expect that the US will suffer stagflation. The Trump administration’s steep tariffs are a supply shock for the US economy. We expect US core inflation, excluding food and energy, to peak above 3% in 2025.

For the rest of the world, growth will be less affected but still subdued from the demand shock of lower exports to the US.

In Europe, higher US tariffs are likely to keep GDP growth in 2025 sluggish and below 1.0% for the third consecutive year. We expect the European Central Bank (ECB) will lower interest rates modestly further. But with European countries beginning to sharply increase defence spending, the ECB may not cut rates much below 2.00% now.

In Asia, US tariffs are set to curb the region’s exports. We expect China’s GDP growth to slow from a solid 5.0% last year towards 4.0% this year. To support growth, Asian governments are set to run larger budget deficits.

We expect further US Dollar weakness; volatile US Treasury yields and strong demand for safe haven assets including gold during the second half of 2025.

US – The Fed is splitting on interest rates

In the first half of the year, the Federal Reserve (Fed) has kept interest rates unchanged at 4.25-4.50% as it waits for more clarity on whether the Trump administration’s sweeping tariff hikes will cause inflation to rise well above its 2% target this year.

In his latest testimony to Congress, Chairman Jerome Powell repeated his view from June’s Federal Open Market Committee (FOMC) meeting that the Fed would keep leaving interest rates unchanged.

The Fed Chair observed that the US economy remains solid: “despite elevated uncertainty, the economy is in a solid position. The unemployment rate remains low, and the labour market is at or near maximum employment. Inflation has come down a great deal but has been running somewhat above our 2% longer-run objective.”

Powell warned that tariffs may raise inflation: “increases in tariffs this year are likely to push up prices and weigh on economic activity.”

Last, Powell said officials can wait-and-see: “for the time being, we are well positioned to wait to learn more about the likely course of the economy before considering any adjustments to our policy stance.”

In contrast, President Donald Trump continues to sharply criticise the Fed for not cutting interest rates.

Moreover, previously hawkish Fed Governors Christopher Waller and Michelle Bowman are also calling for the Fed to ease now as tariffs have had little impact on inflation so far. Both officials are candidates to replace Powell as Fed Chair in May 2026. Their call for early rate cuts will be welcomed by President Trump but may appear a political move by other Fed officials.

We think the majority of the FOMC will vote to continue leaving the fed funds rate on hold unless the US labour market deteriorates over the summer. We thus keep our view the Fed will cut interest rates only once this year, leaving the fed funds rate above 4.00% still as core inflation is set to peak at over 3% in 2025 rather than fall towards the Fed’s 2% target. We also stay cautious on long-term US Treasuries given the risk that inflation will force the Fed to keep interest rates higher for longer during the second half of the year.

China – Growth is resilient but weak links remain

In the first half of 2025, China’s growth has been resilient despite the shock from the US trade war.

The National People’s Congress (NPC) in March agreed to increase the central government’s budget deficit target for 2025 from 3% to 4% of GDP, a rare move, to help fund more infrastructure spending. Subsidies for consumption have boosted retail sales growth to 6.4% year-on-year (YoY). And, in May, the People’s Bank of China (PBOC) announced its first interest rate cut since September, lowering its 7-day reverse repo rate 10bps to 1.40%.

But China’s weak link remains trade. China’s export growth has fallen from last year’s double-digit increases.

At the same time, overall demand in the economy remains subdued. Consumption may slow as subsidies finish. Property investment continues to contract by more than 10% YoY and demand for credit remains lacklustre, rising by less than 9% YoY.

We thus keep our forecast for GDP growth to slow from last year’s solid 5.0% pace to 4.2% in 2025. The economy is withstanding US trade war, but faster growth will require more stimulus in the second half of the year.

Europe – Fiscal stimulus will cushion growth

So far this year, the Eurozone and the UK have withstood the impact of steep US tariff hikes. Though growth is likely to be sluggish for 2025 - around 1% of GDP, we expect both major economies will avoid a recession. Moreover, Europe’s outlook is improving with its growth set to pick up in 2026 as our GDP forecast table shows.

First, the ECB has been cutting interest rates consistently since last year from 4.00% to 2.00% as inflation has returned to its 2% target. We expect one last cut to 1.75% this year.

The Bank of England (BOE) has been reducing interest rates more gradually by 25 basis points (bps) each quarter over the past year from 5.25% to 4.25% given higher inflation in the UK but may accelerate its rate cuts to 3.75% or lower as Britain’s labour market slows.

Second, fiscal policy is set to loosen significantly after NATO countries agreed to spend 3.5% of GDP a year on core defence requirements, up from 2.0% currently. The new target will take 5-10 years to be fully reached but Germany has already begun to raise its budget deficit sharply to more than 3% of GDP from this year onwards.

Thus, looser monetary policy and stronger fiscal stimulus are likely to cushion growth this year and accelerate activity in 2026.

Japan – Outlook clouded by trade war risks

US trade threats are clouding the outlook, hurting the JPY and making the Bank of Japan (BoJ) hesitant to raise interest rates. We expect Washington and Tokyo to reach a deal but Japan’s GDP growth is likely to be just 0.6% this year given the uncertainty. Once a deal is reached, we expect the BoJ will resume its gradual rate hikes, lifting its overnight rate from 0.50% to 0.75% by the end of 2025 and helping the JPY rebound from its current lows of 145 against the USD.