Why We Think UK Growth Cooled in Q3

Editors’ Note: MarketMinder Europe is politically agnostic, preferring no party nor any politician. We assess developments for their potential economic and market implications only.

So this is it, the last UK gross domestic product (GDP, a government-produced measure of economic output) report before Chancellor of the Exchequer Rachel Reeves unveils her Budget next week. And in our view, it was kind of a damp squib. Growth continued in Q3, barely, missing expectations and the worst reading since Q4 2023’s contraction.^[i] Positively, though, we don’t think Q3’s weak results or the reasons for them are sneaking up on stocks.

We found the numbers middling overall. GDP grew 0.1% q/q (0.3% annualised), with government spending and investment contributing most to growth.^[ii] This isn’t inherently a bad thing, in our view, as we find government activity ripples through the economy. But it papered over some private sector weakness. Positively, household spending sped from 0.4% annualised in Q2 to 0.7%.^[iii] But business investment fell again, compounding Q2’s -4.3% annualised drop with a -1.0% slide.^[iv] Net trade contributed positively, but only because imports (which represent domestic demand and are subtracted from exports in GDP’s maths) fell more than exports. So at face value, we think the only good news is that consumer demand rebuked widespread warnings we saw of weakness driven by businesses trying to pass on April’s tax hikes.^[v]

But based on our research, stocks don’t really deal in face value. We find they move most on the gap between reality and expectations, and by that, we don’t mean how headline results compare to consensus estimates. We are talking about broad sentiment—headlines, narratives, the societal mood. Experience tells us that can often be darker than the estimates churned out by economists’ models. And across all national UK publications we follow, economic coverage has consistently reflected much sourer sentiment than the consensus forecasts projected.

So from markets’ standpoint, we think it is less about how Q3 squared with those forecasts and more about how it fits in with the general narrative. Here, the picture we see is sort of mixed. One popular take, which Reeves jumped on, was that Q3’s weakness stemmed from the cyber attack on a major automaker, which idled production lines in September.^[vi] The industry breakdown of GDP, which shows manufacturing down -3.1% annualised and services up 0.8%, seems to support this.^[vii] But we don’t think idled production lines explain falling business investment.

What might explain it: Uncertainty is high right now, in our view, due largely to the aforementioned Budget. For months, we have seen rampant chatter about draconian tax hikes.^[viii] Most of that centered on individuals, but when tax hike fears pervade the general zeitgeist, we find businesses tend to get jittery that they might get hit. Knowing taxes might change—whether through outright hikes or changes to investment allowances, depreciation and other nuanced parts of the tax code—but not knowing the specifics can create a powerful incentive to wait. We aren’t suggesting His Majesty’s Treasury is cooking up something hugely destructive for business. Just that it can be hard to calculate an investment’s projected return when you have a question mark (or marks) in the tax column. Waiting a few months to replace those question marks with numbers starts looking very sensible.

Now, we think stocks know all of this. To us, it stands to reason that they have seen all the Treasury’s trial balloons, all the forecasts and all the opinion pieces trying to hash out the implications given how widely all have circulated. We find business uncertainty is also a very well-known force, visible through numerous surveys, industry reports and executive interviews. Our research suggests markets reflect all widely known information, and whilst we think this uncertainty is a general headwind, it hasn’t kept UK stocks from continuing to clock new highs.^[ix] We think its effects are visible more in relative returns, like the UK’s underperforming eurozone markets this year.^[x]

To us, that is the bad news. The good news? We find falling uncertainty benefits markets, and we see a lot of room for UK uncertainty to fall. We suspect that might be the Budget’s primary market implication: It lets everyone see the lay of the land and enables them to move on. That includes businesses, which will be able to calculate rates of return, figure out the best projects to launch and have at it. Now, this might not be instantaneous, given Labour’s simmering backbench rebellion over tax hikes and resurgent campaign against Prime Minister Keir Starmer.^[xi] Reeves has also reportedly already retreated from raising income tax rates.^[xii] There could be further retreats, retreats from retreats or other changes between the Budget’s unveilling and eventual passage. So uncertainty’s fall may be more gradual, especially if that backbench row turns into a challenge to Starmer’s premiership (unknowable now, in our view). But if it leads to tax hikes getting watered down from expectations, we think that is probably another positive.