Strong investment has helped to offset the drag from geopolitical uncertainty

The UK economy continued to chug along in Q2. Growth of 0.42% Q/Q represented a slowdown from the 0.63% recorded in Q1 but should be seen as a solid result against the backdrop of geopolitical uncertainty. To put it in context, we are now tracking annual average growth at 1.2% this year – which is what we expected back in January (see here) – and risks around that seem tilted to the upside.

It has certainly been a story of resilience. Geopolitical uncertainty did not prevent a solid uptick in business investment (1.7% Q/Q), with overall fixed investment the largest contributor to the quarterly GDP growth rate. Private consumption was the other key growth driver. Government consumption detracted modestly from growth, while net trade made a negligible contribution.

It’s worth flagging that the soft government consumption figure follows the closure of some schools during the second-warmest June on record. Hot weather may have also weighed on construction output. But the monthly GDP release noted a weather-related boost for retail, accommodation and recreation activities, which was bolstered too by the FIFA World Cup.

More fundamentally, the UK economy is being supported by the services sector (0.5% Q/Q), especially from non-customer-facing sectors which are less exposed to (i) interest rates than e.g. real estate and (ii) inflation pressures than e.g. retail and hospitality. Indeed, we see something of a broad cyclical recovery in professional services, with AI adoption likely providing an additional tailwind.

That is increasingly showing up in the capex figures. The ONS noted that the main drivers of investment growth were “information and communication technology, and other machinery and equipment, especially hardware investment”. We think there is some interaction with the post-Brexit catch-up dynamic. After an extended period of caution amid high domestic uncertainty, AI diffusion may be proving a catalyst for stronger capex. 

The economy is carried a degree of momentum into Q3

Looking ahead, monthly GDP growth of 0.3% M/M in June represents decent momentum into Q3. The carryover implies that, if monthly GDP were flat through Q3, quarterly growth would come in at 0.2% Q/Q. We had pencilled in a figure of 0.25% previously, but risks around that are skewed to the upside. Various indicators suggest that activity remained relatively firm last month, despite re-escalation in the Middle East. Survey data generally came in stronger, the ONS reports that retail footfall improved and the World Cup boost to hospitality will likely have extended into the start of Q3.

Recent history suggests that UK growth starts the year strongly before growth fades in H2. This pattern is partly attributable to what we call ‘policy seasonality’ (see here). Speculation ahead of the Autumn Budget has weighed on sentiment and activity in the last two years, followed by a growth rebound once there is clarity.

It will be hard to avoid a similar story this year. The new PM, Andy Burnham, has enjoyed something of a bounce in favourability surveys. But the same fiscal challenges remain.  Yes, growth has been relatively firm – the OBR’s latest calendar-year growth forecast of 1.1% for 2026 looks too low and, as noted above, we track it a little higher. That is modestly positive for the fiscal headroom calculation. But, on our tracking, the headroom of £23.6bn estimated by the OBR in March could be substantially eroded before any new measures, due to higher borrowing costs and a new defence spending commitment. The new chancellor, Healey, has publicly committed to meeting the fiscal rules “with a buffer”. That will be difficult. We expect fiscal speculation will once again weigh on output in Q3 and Q4.

The other headwind will be inflation, which is set to rise over coming months and chip away at real disposable income growth. We see a peak CPI rate of ~3.5% in Q4 as energy-related costs are set to continue to percolate through the economy. This will contribute to an extension of the bumpy GDP profile seen in recent years.

In terms of the monetary policy outlook, our base case remains that the BoE will leave rates unchanged. As yet there has been scant evidence of any second-round effects from higher energy prices into broader inflation. Survey evidence, such as the BoE’s DMP figures (which contain special US-Iran-related questions on pass-through), is not ringing any alarm bells. There also remains a clear degree of slack in the UK labour market, with vacancies below pre-pandemic levels. But with the US-Iran situation remaining unresolved, risks to the call are clearly tilted towards a degree of tightening, and any rate increase would be another headwind for activity.

UK inflation to begin its upward drift

There’s a whole raft of UK data next week, including July CPI, labour market figures, public finances data and retail sales. The focus will be on inflation, which is set to rise on higher energy costs after the household price cap increased by 13% in July. We expect a headline rate of 3.0%, but the BoE and market participants will focus on underlying (i.e. services) pressures. The flash PMI for August will also be released and will be scrutinised for any sign that firms are becoming more confident in passing on higher input costs. In the euro area, the PMIs will be examined in a similar light. The ECB’s negotiated wage indicator and household inflation expectations will also be released, and ECB president Lagarde and chief economist Lane will make public appearances. We continue to expect one more ECB rate hike, in September.