Slow going
The Labour government, now in power for a year, has likely discovered that managing an economy is more difficult than being in opposition.
The UK economy is currently experiencing sluggish growth, with Q1 2025 GDP rising just 0.7% year over year—a figure boosted by trade activity brought forward to avoid tariffs and a one-off effect unlikely to be repeated.
Going forward, real wages growing at a healthy mid-single-digit pace could provide a tailwind as consumers appear willing to spend. In addition, a 10-year, £725 billion infrastructure programme may also offer support; however, at around 2% of GDP per year, it is only a modest increase over the previous government’s spending and in our view not a game changer. Overall, RBC Capital Markets expects subdued growth of 1.0% and 1.1% this year and next respectively.
Labour’s straightjacket
The government is not positioned to stimulate the economy meaningfully. The nation’s fiscal situation is precarious, and Labour has chosen to maintain a set of self-imposed fiscal rules similar to those of the previous Conservative administration, in an effort to signal fiscal responsibility and reassure financial markets.
Top and bottom three countries in terms of fiscal health
The UK sits firmly near the bottom
Notes:
1. RBC Global Asset Management Fiscal Health Index (1 = best; 5 = worst).
2. A negative fiscal deficit indicates a surplus.
This is a simplified excerpt from RBC Global Asset Management’s Fiscal Health Scorecard, which analyses the fiscal health of 27 countries across nine variables. All indicators are based on 2024 data except interest payments (2023).
Source - RBC Wealth Management, RBC Global Asset Management, International Monetary Fund, Macrobond
Labour’s attempts to improve the country’s fiscal health and reduce its debt—such as cutting fuel subsidies for the elderly and reducing welfare payments—have proven difficult and unpopular with the party and voters. As a result, the government has been compelled to water down key elements of its flagship policies.
Meanwhile, pressure to boost defence spending has grown, as U.S. security support appears to be waning, while borrowing costs have risen due to a larger debt burden and higher financing costs.
In our view, the UK Chancellor of the Exchequer has three unpalatable options:
- loosen the fiscal rules and risk a rise in bond yields as markets grow uneasy;
- cut public spending further and risk triggering internal party rebellion and voter backlash; or
- raise taxes and break manifesto commitments.
Although the UK’s tax burden is already at its highest since the 1970s, we think further tax increases are likely to be announced in the autumn budget.
Trade relationship resets
While fiscally constrained, the government has taken steps to mitigate trade setbacks with the U.S. and rebuild the relationship with its major trading partner, the EU.
The U.S.-UK trade deal came into effect on June 30—the only formal agreement implemented during the Trump administration’s 90-day tariff pause. Unfortunately, it offers limited relief to the UK, which retains the 10% blanket tariff, matching the reciprocal U.S. rate. The UK also continues to face a 25% tariff on steel, despite ongoing efforts to have this reduced. Nevertheless, certain sectors are better off: tariffs on UK car exports to the U.S. have been reduced to 10% from 25% and the aerospace sector benefits from zero tariffs.
Meanwhile, Labour has reset the country’s relationship with the EU, rolling back some of the obstacles introduced by Brexit. The new EU-UK agreement covers fisheries, energy trading, veterinary standards for agriculture, and cooperation on defence and security. It aims at reducing some costs of regulatory compliance and border checks, and could provide some benefits to these industries. Though further rapprochement with the EU is likely in the future, we believe the agreement is unlikely to have a marked impact on overall short-term UK growth.
The Bank of England’s own challenge
If the government is reluctant to deploy fiscal stimulus, the Bank of England (BoE) is equally cautious about loosening monetary policy too quickly. Headline inflation has remained stubbornly above the 2% target, coming in at 3.4% year over year in May. As a result, since it started its rate cutting in July 2024, the BoE has acted conservatively, reducing interest rates only to 4.25% from their 5.25% peak.
More cuts are likely later this year and next, in our opinion. Business hiring intentions have softened and are likely to weaken further, which could dampen wage growth and, in turn, ease headline inflation in the second half of the year. Markets expect three additional rate cuts over the next 12 months, bringing the terminal rate to 3.5%, though additional cuts are possible if the labour market weakens markedly.
Value opportunities
Despite the challenging macro backdrop, we believe there are select opportunities in the UK for investors. The FTSE All-Share Index trades at 13.2x price to forward earnings and well below its median price-to-earnings ratio relative to global developed markets, even accounting for sector differences. Some quality UK large-cap stocks trade at a valuation discount to foreign competitors and are an attractive opportunity for global investors seeking diversification, in our view. We also favour attractively valued Financials, given their high level of shareholder returns via both dividends and share buybacks.
In fixed income, though fiscal concerns and expectations of stubborn inflation have led investors to demand higher yields on long-dated bonds, we believe that 10-year Gilt yields above year-to-date averages of 4.6% are compelling. We are also biased towards short-dated Gilts.
As for corporate bonds, we believe that spreads generally are inadequately compensating for credit risk elsewhere, especially in high-yield bonds. However, we see value in short duration senior-ranked bank bonds, as well as Consumer Staples and Communications sectors.