• UK PM Starmer was already under plenty of pressure before Labour’s by-election defeat and the initial market reaction to the result has been muted. The local elections in May, which will provide a cleaner indication of national trends, remain the more likely trigger for a leadership challenge. The government will hope to restore some calm next week with a low-key Spring Statement, where it is sure to highlight improving public finance numbers, but it looks a narrow path ahead. Political uncertainty remains the key UK risk theme.

Another set-back for the UK government ahead of key local elections

The risk of a leadership contest remains elevated

The result of yesterday’s by-election in Manchester rekindles speculation around the future of UK PM Starmer. His Labour party came third with 25.4% of the vote, well behind the Greens (40.7%) and also Reform UK (28.7%). This was a seat Labour won with a comfortable 37 point majority less than two years ago at the general election.

It’s easy to overinterpret by-election results – government parties generally do badly – but the result does reinforce the sense that Labour is struggling as the UK political landscape fragments. The most recent national poll from YouGov shows the five largest parties polling within a 10pp range. Within that, Labour’s support has dipped below 20% and pressure continues to mount on Starmer personally. His approval ratings are dire and prediction market prices imply a ~70% chance that he will be ousted as PM at some point this year.

The obvious flashpoint ahead will be the May local elections, which will provide a clearer picture of Labour’s national support. A sharp, broad-based fall in Labour’s vote share in the spring would be much harder to dismiss.

If Starmer is forced out, the absence of any clear successor with broad support points to a tightly contested leadership battle and increased policy uncertainty. There is certainly a risk that candidates could make spending pledges in a tight race that unsettle markets.

For now, the gilt market reaction to the by-election result has been subdued. Nothing really changes with the by-election result – it’s been clear for some time that Starmer is under the cosh. Our assumption is that an alternative Labour PM would tilt leftward with more tax and spend. But we also assume that candidates for chancellor under a different Labour PM would be market-aware and have a grasp of both the UK’s tight fiscal position and potential flightiness of investors. The Liz Truss ‘mini-Budget’ saga remains a cautionary tale and reduces the scope for radical policy shifts.

On the growth front, political uncertainty remains the obvious downside risk to the UK macro outlook (so much for hopes of stability under this government). Recent economic data has been mixed. Q4 growth was disappointing, services inflation looks sticky and unemployment has risen to a five-year high. But growth momentum at the start of the year looks brighter, with a solid February PMI suggesting that it’s not just a post-Budget relief story. The January public finance numbers were also notably encouraging with signs of stronger tax receipts.

There is a risk that policy drift and persistent speculation around a leadership challenge could weigh on business sentiment over coming months. But, looking through the noise, the macro fundamentals look OK. Mechanical disinflation and further BoE cuts (we expect the next move in March) support our view that UK growth will be reasonably resilient on a quarterly basis this year.

The UK’s political landscape looks increasingly fragmented

Fiscal speculation has weighed on UK business sentiment

Don’t expect any fireworks at the Spring Statement

Attention now turns to next week’s OBR spring forecasts and accompanying government statement. The government has made it clear that it wants the legally-mandated second OBR forecast to be a non-event and we don’t expect any policy changes of note. The lack of speculation is welcome.

There will  be an updated official estimate of the headroom to the fiscal rules, but it’s likely to be close to the figure of 21.7bn from November. It’s less than 100 days since the Budget and the effects of the mixed data flow since then should roughly balance out, but we think the headroom number will break in the government’s favour after a modest fall in borrowing costs.

There will be a few other things to watch. There may be a judgment on the Employment Rights Act. That became law in December (i.e. after the Budget) and could be expected to weigh on hiring. The current unemployment projections already look on the optimistic side to us. It’s also plausible that the OBR will put us on notice about a change in its assumptions for net migration to the UK after the sharp fall in the latest data, as it did last spring on productivity growth. That said, the OBR is still without a chair which may reduce the immediate scope for judgments with significant policy implications. The government will certainly hope so.

The latest public finance figures were encouraging

We expect another year of broad-based domestic growth