Back to school: Fiscal policy and inflation 101

Quick read:

• Fiscal policy continues to trump monetary policy, as expansionary government spending buoys global activity.
• Sustained inflationary pressures are a rising risk in a world of constrained supply and more activist government policy.
• Country-specific shocks and heterogeneous monetary policy reaction functions are creating dispersion and macro investment opportunities.
  

Markets were shaken and stirred by a novel set of policy developments this year. Many of 2025’s asset price moves can be more easily interpreted when viewed in the context of the euphoric US exceptionalism rally that dominated Q4 of 2024. Market attention and relative asset price moves have been dominated by swings in sentiment around US vs. non-US assets – clearly seen in the visual below – but there have also been a series of meaningful country-specific developments outside the US that have catalyzed shifts in our portfolio positioning.¹

The last three quarters have seen notable sentiment shifts and asset price moves

Our investment process focuses on identifying dislocations between macro fundamentals and market prices – and early-year volatility offered plenty of tactical opportunities. We shifted portfolio positions as growth and inflation fundamentals diverged across countries while also capitalizing on price overshoots to unique policy pronouncements. As we enter the final stretch of the year, we outline a handful of macro developments that are informing our portfolio positioning.

Uncle Sam’s (is not the only) open wallet

The passage of the One Big Beautiful Bill Act (OBBBA) and the sunsetting of the Inflation Reduction Act (IRA) set the stage for a US capex and construction expansion in the coming quarters. Global corporations have large tax incentives to build structures, datacenters, and manufacturing in the US and a healthy American consumer should provide sufficient demand to back those investments. This boost in activity will come at the expense of a multi-year deterioration in the US budget deficit outlook that now looks materially worse compared to last year’s consensus estimates.

The dominance of fiscal policy as a driver of nominal growth is increasingly a global phenomenon. Germany’s pivot towards deficit spending has been one of 2025’s biggest macro surprises and the associated increase in bond issuance has us positioned short German Bunds. In contrast to the US and Germany, Japan’s exit from decades of debt deflation and sustained, higher nominal growth have improved that country’s fiscal outlook; we’re positioned long Japanese equites and long the Yen.

The fiscal outlook in the US and Germany has shifted to structural budget deficits whereas Japan is now forecast to cyclically improve

3 is the new 2 for Inflation

Inflation has been a first-order driver of consumer and corporate behavior throughout this US tariff episode. Firms rushed to frontload imports, consumers pulled forward durable goods purchases, and post-Liberation Day price uncertainty slowed real activity in the second quarter. For central banks, this behavioral sensitivity to price shifts is a key challenge for maintaining price stability: inflation isn’t just sticky – it’s shaping economic decision-making.

One driver of recent inflation persistence has been electricity prices. Power prices have meaningfully diverged across countries – driven by a mix of regulation, Russia’s invasion of Ukraine, and recent AI datacenter demand – but the general direction of travel for the price of this critical input is up. Rising demand and inelastic supply is always a catalyst for price inflation, and we see rising risks that US electricity prices will converge toward higher global levels and entrench above target services inflation.²

Electricity prices are rising globally, with idiosyncratic country dispersion

Overbudget monetary renovations

Central banks across the world have been tweaking their policy stances and reaction functions throughout the year. Some shifts that we have our eyes on include:

1. In Europe, the joint opinion piece in January by the presidents of the European Central Bank and president of the European Commission³ signaled an embrace of monetary-fiscal coordination that kicked off a re-rating of European asset prices that we see as largely completed. We are short European equities.
2. The UK’s quantitative easing (QE) capital losses remain politically sensitive, and the Bank of England seems poised to slow active bond sales while the Debt Management Office has simultaneously hinted at shortening the maturity profile of future bond auctions. We are positioned long UK Gilts.
3. In the US, we see growing signs that the Federal Open Market Committee (FOMC) is open to easing front-end policy rates despite persistent upward pressure on inflation. At the same time there are more FOMC discussions about shortening the duration of the Fed’s balance sheet. We are short 30-year US Treasuries and short the US dollar.

So what does it all mean for portfolios?

As kids return to school, we see a backdrop of resilient global growth with continued upside risks to inflation. Financial conditions are loose, fiscal stimulus could again crowd in private sector investment, and a mix of delayed consumption and expiring capex incentives should boost activity into year-end. The continued entanglement of fiscal and monetary policies keeps us mindful of the strong economic impulse of coordinated policies, particularly if the Fed opts to ease into a fiscal expansion.

In our tactical multi-asset portfolios like the BlackRock Tactical Opportunities Fund, we seek to deliver diversifying returns that are lowly correlated with stock and bond markets. We do so primarily by seeking out relative value opportunities across countries’ stock, bond, and currency markets. We implement our active global fixed income insights in the iShares Global Government Bond USD-Hedged Active ETF (GGOV).

To obtain more information on the fund(s) including the Morningstar time period ratings and standardized average annual total returns as of the most recent calendar quarter and current month end, please click on the fund tile.

The Morningstar Rating^TM for funds, or "star rating", is calculated for managed products (including mutual funds, variable annuity and variable life subaccounts, exchange-traded funds, closed-end funds, and separate accounts) with at least a three-year history. Exchange-traded funds and open-ended mutual funds are considered a single population for comparative purposes. It is calculated based on a Morningstar Risk-Adjusted Return measure (excluding any applicable sales charges) that accounts for variation in a managed product's monthly excess performance, placing more emphasis on downward variations and rewarding consistent performance. The top 10% of products in each product category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars, and the bottom 10% receive 1 star. The Overall Morningstar Rating for a managed product is derived from a weighted average of the performance figures associated with its three-, five-, and 10-year 60-119 months of total returns, and 50% 10-year rating/30% five-year rating/20% three-year rating for 120 or more months of total returns. While the 10-year overall star rating formula seems to give the most weight to the 10-year period, the most recent three-year period actually has the greatest impact because it is included in all three rating periods.

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