The global economy has entered the second half of the year with surprising strength despite two wars, sharply higher energy prices and persistent geopolitical disruption. Rather than triggering a broad slowdown, the shocks have so far been absorbed by an economy being powered by corporate investment, artificial intelligence and rising defence spending.
That resilience, however, is creating a different problem. Strong growth is keeping inflationary pressures alive and pushing interest rates and long term bond yields higher. For investors, the danger is that the economic heat that is supporting markets today could eventually ignite financial instability.
What’s Happening?
The impact of the Iran war has been substantial. Crude oil prices rose 50% and natural gas prices doubled over the following six months, raising concerns that higher energy costs would eventually weaken global activity.
Instead, economic momentum has strengthened.
Stay ahead of the geopolitical week.
MD Briefing delivers expert analysis across five global fronts — the Indo-Pacific, energy, geoeconomics, European security, and the Middle East — every Monday morning. Free.
Recent data point to unexpectedly strong U.S. employment, upward revisions to second quarter GDP in the euro zone and Japan, rapid Chinese export and import growth, and one of the strongest aggregate corporate profit expansions on record.
The result is an unusual combination of strong growth, geopolitical tension and supply disruption.
That combination is keeping inflation under pressure while making it harder for central banks to justify lower interest rates.
The AI Investment Boom Is Keeping Growth Alive
Artificial intelligence has become one of the most important forces supporting the global economy.
The enormous investment required to build AI data centres is generating demand across construction, technology, electricity and industrial commodities.
Copper illustrates this effect particularly well. The metal, often treated as a gauge of global industrial activity, is approaching record highs and has almost doubled over five years.
Copper prices are being supported by several factors, including supply constraints and tariff concerns, but the AI infrastructure buildout and increased defence spending are also generating substantial demand.
This means the AI boom is not simply a technology story. It is increasingly becoming a major source of physical investment and industrial activity.
Global Business Confidence Confirms the Strength
Business surveys tell a similar story.
JPMorgan’s combined manufacturing and services surveys showed global output increasing for the fifth consecutive month in August, reaching its highest level in more than two years.
The bank’s data indicate global GDP is growing at an annualised rate of around 3.1%, significantly above its estimate of potential growth of 2.3%.
Even more importantly, new orders and expectations for future output are strengthening.
That suggests the current momentum is not simply the result of temporary statistical effects. Businesses are still expecting demand to remain strong.
Why Strong Growth Could Become a Problem
Normally, strong economic growth would be overwhelmingly positive.
The problem today is the environment surrounding that growth.
Energy prices are high, geopolitical tensions are disrupting supply chains, governments are spending heavily on defence and companies are investing aggressively in AI.
If demand remains strong while supply remains constrained, inflation could prove more persistent.
That creates pressure on central banks to maintain or increase interest rates.
And that is where the financial risks begin to accumulate.
The Bond Market Is the First Firebreak
Long term borrowing costs have already risen to their highest levels in decades.
For investors, this changes the traditional relationship between economic growth and bonds.
During the post 2008 period, investors became accustomed to low growth, low inflation and exceptionally low interest rates. Bonds frequently served as a source of protection when riskier assets declined.
That environment may now be disappearing.
Deutsche Bank strategist Jim Reid argues that bonds are effectively returning to their traditional role, where investors focus more on the income generated through bond coupons rather than expecting large capital gains from falling interest rates.
In other words, bonds are becoming bonds again rather than simply vehicles for betting on lower yields.
The “New, New Normal”
But another interpretation is that the world is not returning to either the pre 2008 environment or the unusual conditions of the 2010s.
JPMorgan Asset Management strategist David Kelly describes the emerging environment as a “new, new normal.”
There are elements of the 2010s still present, including ageing populations and inequality. There are also similarities with earlier periods of geopolitical tension, trade disruption and major investment cycles.
But today’s economy has another defining feature: economic nationalism and trade protectionism have returned on a scale not seen since World War Two.
At the same time, AI could fundamentally change productivity.
The result is an economic environment that combines technological transformation with geopolitical fragmentation.
The Debt Problem Makes This Cycle Different
The biggest difference may be government debt.
Governments accumulated enormous amounts of debt after the 2008 financial crisis and again during the pandemic to prevent economic weakness from becoming something much worse.
That debt changes how financial markets may behave during the next downturn.
Historically, government bonds could provide substantial protection when economic activity weakened because investors expected interest rates to fall and bond prices to rise.
But with government debt already extremely high, investors cannot necessarily assume that governments can respond to every downturn with the same degree of fiscal support.
This also means long term government bonds may not provide the same diversification benefits they once did.
Why Investors Are Becoming More Vulnerable
This creates a difficult environment for asset managers.
They want to remain invested because global growth is strong and corporate earnings are expanding.
But they also have to protect portfolios against the possibility that inflation, interest rates and debt market stress could eventually undermine that growth.
The traditional strategy of relying heavily on government bonds for diversification may no longer work as effectively.
Investors therefore need broader sources of protection.
Key Stakeholders
Central banks: They face the difficult task of containing inflation without unnecessarily weakening an economy that remains surprisingly strong.
Governments: High debt levels limit their ability to rely on large fiscal interventions during future downturns.
Corporations: AI and defence investment are driving growth, but higher financing costs could eventually affect investment decisions.
Asset managers: They must participate in strong economic growth while preparing for greater interest rate and bond market volatility.
Technology companies: AI investment is becoming a major source of global economic demand.
Commodity producers: Rising demand for copper, energy and other industrial inputs is benefiting from the investment cycle but also contributes to inflationary pressure.
What’s Next?
The critical question is whether the current economic strength can continue without producing a larger inflation and interest rate shock.
If growth remains strong, central banks may have less room to reduce rates.
If long term yields continue climbing, governments and companies will face higher borrowing costs.
And if higher borrowing costs eventually begin to slow investment, particularly the enormous spending associated with AI and defence, today’s economic strength could become tomorrow’s weakness.
The International Monetary Fund may also revise its 2026 global growth forecast higher from the 3.0% estimate it made in July. Its outlook for 2027 will be closely watched because global growth is already expected to accelerate to 3.4%.
Analysis
The biggest danger facing the global economy may not be recession.
It may be overheating.
Two wars and dramatically higher energy prices have failed to produce the slowdown many expected. Instead, AI investment, corporate spending, defence expenditure and resilient consumer and business activity are keeping global growth unusually strong.
But an economy cannot run indefinitely above its potential without consequences.
The stronger growth remains, the more difficult it becomes for central banks to ease monetary policy. Higher interest rates then feed into government debt servicing, corporate borrowing and asset valuations.
At the same time, today’s unusually high government debt means policymakers have less room to cushion the economy if something goes wrong.
That creates the possibility of a financial chain reaction: strong growth fuels inflation, inflation keeps rates high, high rates push bond yields higher, and expensive borrowing eventually threatens the investment boom that is supporting growth in the first place.
This is why the current environment is so difficult for investors. The economy is performing well enough that abandoning risk assets could mean missing substantial gains, yet the very strength supporting those gains is creating vulnerabilities elsewhere.
There may be no return to the old “normal” of permanently low rates and predictable diversification.
The world economy is instead entering a period defined by stronger investment, higher debt, geopolitical disruption, protectionism and technological transformation.
The financial risk is not that the global economy is too weak.
It may be that it is running too hot and that the financial wildfire begins when policymakers finally have to put the brakes on.
With information from Reuters.
