The AI growth story and an impending change at the top of the powerful US Federal Reserve are gripping investment pundits ahead of 2026.

Jerome Powell, the outgoing boss of the Fed, looks certain to be replaced by a candidate more willing to do US president Donald Trump's bidding and cut interest rates more deeply despite inflation risks

Concern about an AI stock market bubble, upheaval at the Fed, and the possibility Trump's controversial tariff policy will be thrown out by the US Supreme Court have big implications for the rest of the world.

Interest in diversifying away from the US has already benefited European and UK markets, and so has the step-up in defence spending by western countries wanting more independence from a volatile Washington under Trump.

We look at how events might unfold in the world's markets and round up some fund ideas for the year ahead.

The US: Inflation could reignite under Trump's policies

'The US economy is not going gangbusters,' says Emma Wall, chief investment strategist at Hargreaves Lansdown.

'The jobs market is weakening, adding to expansion concerns heading into 2026. But Trump is keen for it to do better as he heads into mid-term elections next year.'

Wall notes that Trump has mooted the idea of issuing 'tariff cheques' to the public, while his so-called One Big Beautiful Bill drip-feeds tax cuts and spending into the system, adding more debt to a country already running a record deficit.

'If you pump too much stimulus into the system, and stoke too much demand, inflation will reignite,' she warns. 'This in turn could mean the Federal Reserve is forced back into a hiking cycle, which equity markets will not like.

'It is a difficult balance to get right – and it will create volatility in the bond market, which in turn creates opportunities for the tactical investor.'

Paul Diggle, chief economist at Aberdeen, is forecasting US GDP growth of 2.2 per cent in 2026 and 1.9 per cent in 2027, supported in part by a tailwind from AI capital spending and interest rate cuts.

But he cautions: 'There is a clear risk of an AI bust driving a recession. While not our base case, this downturn would look more like 2001 than 2008.'

And he adds: 'Should the Supreme Court rule US president Donald Trump does not have tariff powers under the International Emergency Economic Powers Act, trade uncertainty may spike again. We think the president would find alternative means to re-build tariff levels to around 15 per cent.

'But any loss of tariff revenue could trigger concerns about the fiscal trajectory. The tariff impact on prices has not yet peaked, and we expect US inflation to reach 3.4 per cent in the first quarter of 2026. Inflation should ease to 2 per cent by the end of 2026.'

Japan: ‘Sanaenomics’ spurs a new push for growth

New prime minister Sanae Takaichi is driving an agenda dubbed ‘Sanaenomics’, says Thomas Smith, fund manager in the Liontrust Global Equities team.

Aggressive fiscal action focused on tax cuts, spending increases and measures to counter inflation is designed to boost sluggish middle-class consumption, he explains.

This is blended with shareholder-friendly structural reforms, including supply-side reforms with similarities to ‘Abenomics’ under Takaichi's late predecessor Shinzo Abe.

Smith says Japan is employing targeted strategies for cutting-edge industries like semiconductors, AI, quantum computing and critical minerals, and an accelerated timeline for defence spending increases and nuclear power plant restarts.

'The transition from deflation to a cycle of sustainable, moderate inflation is fundamentally changing the Japanese economic landscape. Driven by tight labour markets and rising services prices, this is unlikely to be helped by Takaichi’s restrictive stance on migration.'

Smith says the Tokyo Stock Exchange's campaign to improve capital efficiency continues to drive value creation, with the momentum of share buybacks, dividend increases, and business restructuring bolstering shareholder returns.

'Takaichi is a strong advocate for corporate governance reforms, specifically targeting the effective use of retained earnings. This aligns with the TSE's ongoing push for firms to address low price/book ratios and improve return on equity.'

Europe: Defence spending reverses years of under-investment

'The market still seems too bearish on Europe, where we find plenty of strong investment ideas,' says Mark Hawtin, head of the Liontrust Global Equities team.

'Europe is constantly under fire for being backward thinking on structural reform and investment, but this is changing.'

Spending on defence and power infrastructure are reversing 25 years of underinvestment, although a stronger euro is not ideal for many of the quality names in the market, cautions Hawtin.

'Valuations are reasonable and the reverse of the Magnificent Seven effect is in play in Europe, with the largest cap names having underperformed for some time.'

Tom Bailey, head of research at HANetf, says European defence has been a standout theme in 2025 and he expects continued interest next year.

'The key driver has been recognition of Europe’s vital need to up its defence spending, considering geopolitical realities. But we also believe that interest in the defence theme will now expand beyond European defence companies.

'Just as Europe came under pressure from the US to spend more, so too are Asian countries. Rearmament is a global trend, unfortunately.'

Jack Featherby, portfolio manager at JPMorgan European Discovery Trust, says: 'Europe’s economy looks set for a rebound, powered by falling interest rates, increased defence and infrastructure spending, and policy reform.

'The reshaping of US trade policy and Europe’s renewed push for self-reliance are already creating tailwinds for domestically focused small caps, which we believe are the biggest beneficiaries of this new environment.'

Featherby reckons valuations remain unusually cheap, with small caps now trading at a discount to large caps.

'We see the biggest opportunities in industrials, technology and healthcare, where innovation and capital investment are accelerating.'

China: AI breakthroughs achieved more cheaply than in US

China's trade détente with the US removes some of the downside risks to its growth outlook but challenges persist, according to Aberdeen's chief economist Paul Diggle.

He cites the anti-involution campaign - an attempt to curb unnecessary industrial competition, price wars and over-capacity - which may introduce a new drag on investment. Plus, he highlights problems in the housing market and subdued consumer confidence.

'We forecast further stimulus. But this will remain focused on investing in strategically important sectors on the supply rather than demand-side. Therefore, it won’t do much to boost ingrained low inflation. All told, we have raised our 2026 Chinese GDP forecast to 4.5 per cent.

'That would still be a step down from this year, and we are forecasting a further deceleration in 2027. We’ve lowered our inflation forecasts.'

On the AI front, Kevin Carter, manager of the EMQQ Emerging Markets Internet ETF, says China's internet giants are delivering highly competitive breakthroughs at a fraction of US development costs.

'Despite spending roughly $125billion across 2023–25 - compared to nearly US$700 billion by US hyperscalers - Chinese models have already reached about 90 per cent of US performance benchmarks.

'Baidu is rolling out custom AI chips and supercomputing systems to reduce hardware dependence and lower model-training costs, deploying these tools across its ecosystem, including its fast-growing robotaxi business.

'Alibaba is aggressively open-sourcing models and embedding AI across commerce, logistics, and cloud operations, while Tencent is integrating AI into gaming, social platforms, cloud, and advertising.'

Carter says these initiatives position China for a leap in AI commercialisation as its companies deploy advanced models at scale, supported by smarter cost structures and deep domestic demand.

Want to diversify away from the US? Funds to consider for 2026

Hargreaves Lansdown says that as a small number of large US companies have driven much of the market’s recent gains, diversification remains key. It highlights three funds to help you do that next year.

Schroder Managed Balanced [Ongoing charge: 0.91 per cent]

Multi-asset funds that blend shares, bonds and other investments aim to capture growth when markets rise while offering some shelter when they fall and can help reduce concentration risk, says Hargreaves.

'The Schroder Managed Balanced fund is a "fund of funds". The managers mainly invest in other Schroders funds, run by specialist teams investing in hundreds of different companies and bonds worldwide. This creates plenty of diversification across geographies, sectors and asset types.

'The team tends to favour shares when the economic environment looks positive. But in times of stress, they shift towards more diversified assets, including bonds, cash and alternatives, with the aim of minimising losses. They also have the flexibility to invest in thematic areas, such as gold, which can provide additional resilience.'

JPMorgan Emerging Markets [Ongoing charge: 0.84 per cent]

'Emerging markets have played second fiddle to the US in recent years, but that hasn’t always been the case and at some point, the balance could shift,' says Hargreaves.

'Valuations in developing markets look appealing relative to their developed peers, and the long-term growth story remains intact.'

The online broker says many emerging markets economies are supported by powerful structural trends, such as rising wealth and expanding consumer demand - but a key factor to watch in 2026 is the US dollar.

'If it continues to weaken, as some expect, that could be good news for emerging markets. A softer dollar typically reduces borrowing costs for these economies and can encourage investment flows.

'The JPM Emerging Markets fund is managed by experienced investor Leon Eidelman, supported by a network of more than 100 investment professionals across nine countries. This gives the team eyes on the ground in many corners of the market.'

Hargreaves notes the fund invests in major countries like India and China, as well as smaller regions offering unique opportunities, including the Middle East, Turkey and Mexico.

Invesco Tactical Bond [Ongoing charge: 0.70 per cent]

Bonds have endured a volatile period, but remain an important part of diversified portfolios by offering income, defensive qualities and potential stability when equities struggle, explains Hargreaves.

'Inflation has come down from its peaks, and many central banks are expected to continue cutting interest rates throughout 2026 – though a cautious approach is signalled. This broadly creates a more supportive environment for bond investors because, as yields fall, prices typically rise.'

But the firm warns the path ahead is unlikely to be smooth, with economic conditions are uneven across regions, so flexibility is key. 

It says Invesco Tactical Bond's managers have freedom to invest across government, corporate, high-yield and emerging market bonds.

'Their approach is built on interpreting the wider economic picture and adjusting the portfolio accordingly. They aim to shelter the fund when they see tougher times ahead and seek stronger returns when opportunities arise.'