Make Britain grow again!

The tax increases in Chancellor Rachel Reeves’ inaugural budget in October last year has raised concerns amongst business leaders about the UK’s growth outlook. Industry groups such as the Confederation of British Industry (CBI) and the British Chambers of Commerce (BCC) highlighted the potential negative consequences on investment, profitability, and economic growth. The hike in employers’ National Insurance (NI) contributions has resulted in many firms citing taxation as a primary issue.

The fear among businesses is that higher taxes and a rise in the National Minium Wage could weaken the UK's competitiveness. At a time when global economies are striving to attract capital, tax policy could make the UK less appealing for international investors. Many businesses are calling for policy adjustments to foster growth rather than inhibit it.

The Office for Budget Responsibility (OBR), the fiscal watchdog, is scheduled to release its updated economic and fiscal forecasts on 26 March 2025. The OBR currently has 2% real GDP growth pencilled in for 2025.¹ However, lacklustre business sentiment suggests that a much lower figure is likely. The Bank of England recently revised down its real GDP growth forecast to 0.75% in 2025 from its previous estimate of 1.5%.²

The OBR’s fiscal outlook plays a crucial role in shaping government’s policies and could have an impact on the gilt market. Should the UK’s growth outlook be revised down, as is likely, then the expected fiscal position would weaken too. As a reminder, the Chancellor’s self-imposed new fiscal rules require that the current budget of day-to-day spending (excluding capital expenditure) to be in balance by 2029/30 and for the targeted net financial liabilities ratio (a broader measure of public debt) to decline by the same year.

There is limited fiscal headroom of just £10 billion to meet the balanced budget rule – a key marker for the maintaining the government’s fiscal credibility with financial markets.³ However, meeting this rule will largely be dependent on the growth outlook. The government’s fiscal targets are based over the medium-term growth outlook of the next five years. Near-term growth estimates may not matter much provided the OBR maintains forecasts that hold up in the later years. However, given that NI tax is permanent, it may be difficult for the OBR to justify an overly optimistic medium growth outlook. JP Morgan estimates that if the OBR cuts its near term growth forecast by 0.5 percentage points for both 2024/25 and 2025/26, while keeping an optimistic average growth of 1.7% onwards, it will cost around £17 billion from this measured headroom.⁴ Though if growth in the later years is revised down the fiscal gap could double.⁵

The government also faces other headwinds to meeting its fiscal targets. These range from the higher cost of borrowing in the gilt market to pressure from the Trump administration for the UK to spend more on defence. However, there is some good news for the government. Higher wages and the hike in the National Minimum Wage should bring in more tax revenues over the coming years.

Overall, JP Morgan estimates that if the government wants to deal with both the expected shortfall and leave fiscal headroom of £10 billion, it will probably need to find savings of around £20 billion in the Spring.⁶

Politically, raising taxes may not be an option for the Chancellor. She would be reluctant to raise taxes as it would go against the Labour party’s manifesto not to hike the major ones. The government also committed to only change taxes once a year during the Autumn budget.

So, that leaves spending cuts as the more likely option. However, this could only occur from 2026/27, as much of the £70 billion rise in public spending from the October budget has already been committed for 2024/25 and 2025/26 after a detailed spending review.⁷ Even cutting spending from 2026/27 will be difficult as much day-to-day spending has been ringfenced, while unprotected departments are already braced for spending cuts in real terms.

Restraining welfare spending may not be viable, as it comes with challenges outside the government’s control, including uncertain trends in unemployment. It also would only happen during a budget.

Perhaps the Chancellor will voice her intention to the OBR that she will cut spending from the later years of this parliament, but without specifying where the cuts will come from. Ultimately, this will be a fudge, and it is not clear if the OBR (or markets) will give the government the benefit of the doubt to meet its fiscal rules by 2029/30. Gilt investors may be particularly nervous to give the government credibility for back-end spending cuts so close to an election (due in 2029). It is also uncertain whether the OBR can continue with its optimistic growth forecasts.

Given the tight government purse strings, Chancellor Reeves is hoping to loosen up planning restrictions on infrastructure and housing to attract private capital into the economy to lift UK growth. She used a speech in January to confirm the government’s support for a third runway at Heathrow and the creation of the Oxford-Cambridge growth corridor. The idea of these projects is to enhance connectivity, increase capacity, and unlock the economic potential of key regions in the UK. The Chancellor will also review the Green Book, which is the government’s guidance on appraising policies, projects and programmes, to give all investment in the regions a “fair hearing”; early findings are due to be reported by the conclusion of the annual Spending Review on 11 June.

While the Chancellor has reintroduced mandatory housing targets (previously advisory), as well as creating a taskforce to accelerate stalled housing projects, it is unclear if this will work. The government may struggle to get projects off the ground due to NIMBYism (Not In MY Back Yard). This phenomenon occurs when residents oppose developments in their area for fear public projects will have a detrimental impact on property values, the environment and quality of life. NIMBYism can lead to bureaucratic delays and prolonged legal battles as residents use the court system to challenge and obstruct projects. However, the government wants to stream-line legal challenges so that unarguable planning cases can only be brought to the courts once from currently, three times. The government is also introducing legislation to reduce the impact of NIMBYism, including a New Planning and Infrastructure Bill due to be published in March. 

The Labour Party has committed to boosting economic growth through infrastructure investment, planning reforms, and decentralisation efforts. However, raising the UK's growth rate will be challenging, given that productivity has remained stubbornly low. It remains to be seen whether the Chancellor’s proposals to scrap regulatory red tape to drive construction will boost the country’s growth outlook.

UK equites are probably less exposed to risks within the gilt market. Despite the country’s economic challenges, large-cap listed companies benefit more from global growth, as UK multinationals generate a significant proportion of their revenues from overseas. Moreover, geopolitical disruptions, such as restrictions on energy supplies, could lead to outperformance in value-focused sectors like energy, where the UK stock market has significant exposure.

In contrast, by setting self-imposed fiscal rules and setting out an ambitious growth agenda, the government has created a stress point in the gilt market. Should the government be seen to be missing its fiscal rules, it is possible that longer-dated gilt yields could rise to reflect doubts over its fiscal credibility, particularly with foreign investors. That’s because given that the UK reports a twin budget and current account deficit, it is heavily dependent on the willingness of foreigners to buy gilts. In the last ten years, foreign purchases of UK debt (mainly gilts) have been largely behind the positive net portfolio inflows. Without these foreign savings, the sterling exchange rate would probably be a lot lower.

However, some good news for gilt investors is that the UK’s fiscal challenges and gilt supply issues are well known, whilst weak growth and moderating inflation (albeit with some nearer-term upward pressure from energy and regulated price changes) should encourage lower yields. Meanwhile, demand for short and medium-term gilts, which offer a real rate of return, could see a boost if the interest paid on cash parked in deposit accounts falls, as the Bank of England cuts the base rate.

Encouragingly, sterling has held up relatively well against a strong US dollar. The prevailing exchange rate for sterling is 1.26, a sharp contrast from when the pound fell to just 1.07 against the Greenback in the aftermath of then Chancellor, Kwasi Kwarteng’s mini-budget in September 2022.⁸ The interest rate environment is also markedly different. With US inflation slowing, the Federal Reserve is cutting interest rates, which puts less downward pressure against sterling.

In short, provided inflation does not make a material comeback, gilts could offer some portfolio protection in the event of a recession. However, investors should be wary of politicians promising growth but failing to deliver and particularly when the Chancellor is under pressure to maintain investor confidence in the UK whilst balancing ideological demands within her party. We could see a bumpy time in the gilt market in the run up to the OBR’s latest assessment of the last budget on 26 March.

^1. Economic and fiscal outlook, OBR, October 2024

^2. Bank cuts interest rates and slashes growth forecast, BBC, 6 February 2025

^{3, 4, 5, 6, 7.} UK: Fiscal options ahead of a spring showdown, JP Morgan, 17 January 2025

^8. LSEG/Evelyn Partners