THE OUTLOOK
Stagflation-lite is now the base case
The economy came back to life in Q1 but that’s probably all the growth the economy will get this year. Rising inflation, a surge in uncertainty and jump in borrowing costs will crimp households’ real disposable income and drag on business investment over the rest of this year.
Slower growth and rising inflation mean 2026 is set to be another year of ‘stagflation-lite’.
Weak income growth will keep spending subdued
Fading uncertainty after last year’s budget meant the economy grew 0.6% in Q1. But now business surveys point to the economy stagnating, or even contracting slightly in Q2, with consumer confidence weakening and inflation remaining above 3.0% through this year.
We now anticipate real household disposable incomes, the best measure of household’s ability to spend, to grow by just 0.4% this year. Wage growth will slow markedly this year, due to the weaker labour market, and any increase in nominal pay is now likely to be almost completely eroded by higher inflation.
Admittedly, households have just rebuilt their savings following the last shock so may be far less willing to slash savings compared to previous inflation shocks and instead prefer to keep a larger buffer. But given the surge in energy prices now looks like a temporary issue, households seem willing to smooth through at least some of the hit.
That said, the impact on consumer spending should be smaller than the impact on incomes as households are saving roughly 10% of their incomes. This means households have plenty of room to offset some of the shock through lower savings for a brief period, as they did in post pandemic when the savings ratio dropped to a low of 3.8% in Q2 2022.
OUR FORECAST
We estimate that consumption will grow by around 1.0% this year, down from our previous forecast of 1.2%.
Businesses will put a brake on investment this year
Elsewhere, we expect business investment, which was already down 1.8% year-on-year (y/y) in Q1, to remain weak throughout this year for three reasons:
Energy price spike
The surge in energy prices will squeeze firms’ margins and prompt some firms to cancel capital expenditure to ensure they have liquidity.
Uncertainty
Both geopolitics and domestic political chaos have prompted uncertainty to spike, which at best will lead some investment plans to be delayed.
Borrowing costs
The combination of higher inflation and the risk of a more spendthrift government have also pushed medium-term borrowing costs to the highest since 2008, which has raised the cost of capital sharply.
Further ahead, growth will probably still be somewhat tepid in 2027, as inflation remains elevated throughout Q1 and backloaded tax rises start to bite. As the year progresses inflation will return to target, allowing the BoE to cut rates and for confidence to improve, lifting growth and offering the economy some much needed momentum heading into 2028.
