The early omens for 2026 are not good. The UK is stumbling into the New Year on the brink of recession. Indeed, the economy stopped growing last summer as Budget jitters began to undermine confidence and spending again.
Only some favourable rounding in August prevented headline GDP from falling in every month from July to October. We are still awaiting the official data for November and December, but the latest business surveys suggest that the economy ended last year with a whimper.
The weakness of the construction sector is symbolic of many policy failures. Despite the Labour government’s calls to “build, baby, build!”, the November Construction PMI signalled that activity is declining at the fastest pace for over five years.
Overall, the UK economy probably grew by around 1.3 per cent in 2025. This would only be a little better than the 1.1 per cent in 2024. More ominously, it would already be a little worse than the 1.5 per cent assumed by the OBR for the November Budget.
There are still some decent reasons to hope that the economy will improve in 2026.
One is that, despite everything, the finances of both the household and corporate sectors are in good shape. Many individual families and smaller businesses will continue to struggle. Nonetheless, the household sector as a whole has been saving a larger than usual proportion of its income for several years.
More of these excess savings could now be used to support higher spending if — obviously a big if — consumers feel confident enough to save less or borrow more.
Similarly, corporate debt ratios are still comfortable, and credit spreads are tight. This means that most firms could borrow more relatively cheaply if — that word again — they have the confidence to do so.
Encouragingly, business investment was already one of the few bright spots of 2025. The UK has also continued to score highly in surveys of attractiveness for inward investment, notably the study by EY.
There are at least three downside risks for 2026
A sustained improvement in the economy still needs a catalyst. But there are several potential candidates, including the easing of the pre-Budget uncertainty, falling inflation and further cuts in official interest rates. At 3.75 per cent, the Bank rate is still towards the top end of a “neutral” range, which is between 3 per cent and 4 per cent.
Unfortunately, that is where the seasonal good cheer runs out. There are at least three downside risks for 2026.
The first is the weakness of the labour market. A few polls suggest that the pace of job losses is slowing and that some firms may be ready to start recruiting again in the spring. Unemployment is also still low by past standards.
However, government policies which have raised the cost of labour and made hiring and firing more difficult have done lasting damage to employer confidence. Household worries about job security have also increased, which is likely to keep precautionary saving high.
The second risk is a resurgence of policy uncertainty, including fears of yet another round of tax increases in the next Autumn Budget Keir Starmer’s premiership is in crisis, and the prospect of a leadership challenge will keep businesses and investors on edge. While it might be difficult to imagine someone doing a worse job, the markets still fear an even more left-wing alternative.
If Rachel Reeves is still in post, the Treasury could simply dust off some more of the “smorgasbord” of increases in taxes on the slightly better off that were floated in the run up to the last Budget. However, a more left-wing Chancellor could increase spending even further, requiring bigger tax increases — including new taxes on wealth.
A desperate Labour government also looks set to waste time trying to “move closer” to the floundering EU rather than make more of the opportunities created by leaving. Ironically, Brexit had dropped way down the list of concerns for the public and, at least as importantly, for businesses. Reviving Brexit uncertainty will do more harm than good, especially as the EU seems as determined as ever to punish the UK for daring to break away.
The third risk is a financial market crash, whether prompted by domestic economic and political factors or by external shocks. In particular, this may well be the year when the Trump balloon finally pops. The key risks to the US economy all lie on the downside — including rising unemployment, the delayed fallout from tariff wars, a fight with the Fed, and the bursting of the AI bubble.
Unfortunately, our own government appears to have given up on growth altogether in favour of policies designed to redistribute income and wealth, and ramping up the size of the state.
For example, the government’s plan to tackle the cost of living crisis is a scrappy list of measures which will do nothing to solve the underlying problems. The interventions on prices should reduce headline inflation, but only temporarily and by just a few tenths of a percentage point. Moreover, taxpayers will pick up the bills instead. This will leave many households no better off, while distorting incentives further.
Meanwhile, government interventions in many areas, notably energy, housing and labour markets, are adding to cost and price pressures. Low productivity in the public sector is dragging the whole economy down.
Labour has crushed the “animal spirits” that drive growth
The upshot is that the economy will continue to struggle in 2026. Even if a formal recession is avoided, growth will be weaker this year than last — perhaps well below 1 per cent in headline terms and barely positive at all after adjusting for population growth.
This will not be enough to end the “doom loop” of deteriorating public finances and ever higher taxes that has already been the hallmark of the Starmer government. Labour has crushed the “animal spirits” that drive growth and it is hard to regain economic confidence once it has been lost.
