Where should you invest in 2026? From the AI bubble, to defence… and surprise

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.

Change at the top: Outgoing US Fed boss Jerome Powell will be replaced by a candidate more willing to cut interest rates

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…