A stronger than expected Q1 raises UK growth forecast. Our economics partner Oxford Economics (OE) has slightly increased its UK growth forecast for 2026 from 0.6% in April to 0.7%. While OE had expected inflation to drop to around 2% before the war started, the rate is now expected to average 3.4%. The return of inflation means that interest rate cuts will stay on hold.
Worst-case trade war
US trade deals prove fragile. The US effective tariff rate rises to 33% in Q1 2026, far above the 13% level in the baseline. China is particularly hard hit, with an effective tariff rate of around 125%. Affected economies hit back with corresponding tariffs on US exports.
Fiscal crisis
Investor concerns over Japan's fiscal position spread to other economies, prompting governments to take action to tackle rising public debt levels. Initial hits to GDP growth are eventually unwound as interest rate cuts from the Federal Reserve and a partial unwind of fiscal measures support recovery beyond 2028.
AI boom
AI-driven investment surge lifts global growth. Booming US tech spending and stock markets, powered by rapid AI adoption and productivity gains, mirroring the upswing witnessed in the 1990s.
Prolonged Iran war
A sustained stalemate leads to the Strait of Hormuz remaining effectively closed for six months. Alternative shipping routes also come under threat, while extended conflict increases damage to energy infrastructure.
Key drivers of the short-term outlook
- The duration and severity of the US/Israel-Iran conflict is uncertain: OE’s forecasts that oil and gas prices will remain elevated in Q2. Domestic energy bills will only increase from July, when the Ofgem Energy Price Cap is expected to rise by around 16%.
- The impact of past rate hikes will continue to emerge: OE estimate that these borrowers face an increase in their mortgage rate of 250bps-300bps.
- Consumers likely to save less: Households have been very cautious in recent years, saving an unusually high share of their income and showing muted demand for credit.
What to watch out for
- Conflict in the Middle East: The conflict’s duration and impact on oil and gas prices are uncertain, but cost hikes would negatively affect the UK due to its reliance on imported gas.
- Elevated fiscal risk. Market reaction to November’s Budget was positive, but fiscal consolidation via tax rises may not meet targets in an election year.
- Challenging political backdrop. Labour's election losses threaten Keir Starmer's position. Drawn-out succession, likely favouring Andy Burnham, undermines UK markets.
- Immigration reforms. Tighter immigration rules may slow growth and create skills shortages.
Produced by the Foresight Factory for the IPA Commercial Group
