The UK economy experienced an unexpected contraction in May, with GDP falling by 0.1% month-on-month. This follows a 0.3% decline in April, defying market expectations of a modest 0.1% growth and sparking renewed concerns about a potential recession later this year.
While the services sector managed to eke out 0.1% growth in May, driven by strength in IT and professional services, this was not enough to offset significant contractions in other key areas. Production output saw a 0.9% fall, largely due to declines in manufacturing, particularly pharmaceuticals and motor vehicles. The construction sector also registered a 0.6% drop, mainly attributed to reduced repair and maintenance work, partly impacted by recent changes to Stamp Duty Land Tax.
Nicholas Hyett, Investment Manager at Wealth Club, commented on the situation, highlighting that “higher US tariffs seem to be causing some of the UK’s woes, especially in car manufacturing.” He also noted that “changes to stamp duty have weighed on the construction sector.” While an optimistic view might see these as temporary headwinds, Hyett questioned what would truly turn the economy around, pointing to potential pressures on labour-intensive industries from higher living wages and increased employer National Insurance contributions. He concluded, “Both weather and markets may be stuck on hot, but ultimately it’s the economy that matters and if cooling turns to economic deep freeze you might see the government start to sweat.”
David Morrison, Senior Market Analyst at Trade Nation, echoed the sentiment of concern. While acknowledging that GDP rose by 0.5% over the three months to May, primarily due to the services sector, he underscored the disappointing monthly figure. “The disappointing monthly GDP number triggered a sell-off in sterling against both the US dollar and the euro,” Morrison stated. “Yet again, this is another poor piece of UK economic data which can only add to Chancellor Rachel Reeves’s woes.” He emphasised that the upcoming quarterly growth figures will be closely scrutinised by investors for signs of a potential return to recession.
Morrison also delved into broader fiscal concerns, referencing the government’s perceived lack of fiscal control and the recent Fiscal Risks and Sustainability Report from the Office for Budget Responsibility (OBR). The OBR’s report painted a sobering picture of the nation’s finances, noting that “Governments have successively reversed plans for fiscal consolidation: planned tax cuts have been reversed; planned spending cuts have been abandoned.” This has led to an increase in debt and a weakening of fiscal rules.
The OBR’s report further highlights that “the capacity of UK public finance to respond to future shocks is significantly diminished and that ‘…the scale and array of risks to the UK fiscal outlook remains daunting.’” This is reflected in higher gilt rates, with the UK now facing the highest borrowing costs of any major advanced economy.
Morrison linked these issues to research suggesting that excessive government spending can hinder economic growth, noting that UK government spending is around 45% of GDP, significantly above the “sweet spot” of 15-30% identified in the research. This high level of public spending can “crowd out private consumption and investment,” contributing to elevated inflation.
Alarm bells may be ringing at the Bank of England regarding “the scale of leveraged positions in gilts.” The risk, Morrison explained, is that this could lead to “fire sale dynamics should these funds need to unwind the trade in a falling market.”