Mind the fiscal gap. Exploring the UK’s budget options

The upcoming Autumn Budget may put the UK’s finances on a firmer footing, while significant monetary easing could help offset its impact on growth. We explore the possible measures, the outlook for investors, and our preference for UK Gilts.

The UK’s Autumn Budget on 26 November will be an important one for the Labour government. The public finances are under pressure, yet any misstep on bringing them under control could put further pressure on Prime Minister Keir Starmer. Budget decisions are usually trailed in the media in the weeks beforehand, and the government has already retreated from plans for an income tax rise that would have broken its election manifesto promise.

With few easy choices ahead, we expect a prudent Budget designed to allay market concerns over debt sustainability, but not a pro-growth one. The focus will be squarely on fiscal consolidation. Assumptions about weaker future UK growth and productivity from the independent fiscal watchdog, the Office for Budget Responsibility (OBR), have in the past eroded any ‘headroom’ for the government to meet its own rules on sustainable tax and spending. Recent OBR assumptions could put the UK’s fiscal shortfall at GBP 20 billion, helped in part by falling Gilt yields; we expect Chancellor Rachel Reeves to seek to structurally increase this buffer.

We expect a prudent Budget designed to allay market concerns over debt sustainability, but not a pro-growth one

Revenue raising

Most of the fiscal consolidation will likely come from tax rises. Spending cuts have proved politically difficult for Labour, even though public spending has increased sharply since the pandemic, healthcare and defence needs are rising, and debt servicing costs are high. Despite a sizeable parliamentary majority, Labour was forced to back down earlier in the year on plans to cut welfare spending, given divisions within its own party. Politically, further tax increases will also be difficult after having raised them in 2024. Indeed, taxes have been rising steadily as a share of GDP for more than 25 years, but they remain below the 40% of GDP average across the euro area, according to European Commission figures. As such, we expect a series of piecemeal revenue-raising measures from the UK Budget, which will do little to simplify the country’s complex tax system.

Overall, the Budget will be a difficult exercise in balancing measures that keep the market, the electorate, and the different factions of the Labour Party happy – making this a politically as well as economically important event.

One government priority will be raising taxes without raising inflation. The UK economy has struggled this year with sluggish growth yet high inflation – one reason why interest rates are some way above other developed economies at 4%. We thus expect the Budget to focus on non-inflationary revenue-raising measures: perhaps freezing or lowering the thresholds at which different income tax bands are paid, increasing property taxes, or changing capital gains tax, the treatment of pension contributions or rental income.

We would also expect steps to ease cost-of-living pressures – such as freezing fuel duty or cutting value added tax (VAT) on household energy bills. Such measures would bring the headline rate of inflation down over the next year, helping the broader disinflation narrative. But their one-off nature means that we would expect the Bank of England (BoE) to largely treat this effect as transitory, with its focus remaining on the underlying trend.

Tax rises in the upcoming Budget could further damage UK domestic demand. Rising food and utilities bills and the effects of prior rate rises on mortgage rates have already curtailed consumer spending and confidence in 2025, contributing to an unusually high savings rate.

Falling inflation and interest rates

Yet weaker domestic demand should also translate into lower inflation. We expect UK consumer price inflation to fall from an average of 3.1% in 2025 to just over 2% in 2026, much nearer the BoE’s target. Services inflation is already falling; wage growth has eased as the job market has weakened. The UK unemployment rate has inched up to 5% and job vacancies have been falling but now look to have stabilised, meaning the bulk of the labour market weakening may now be over.

We expect the Bank of England’s policy rate to reach 2.75% by the end of the third quarter

Falling inflation should in turn allow the BoE to cut interest rates in December and continue to ease policy in 2026. We expect the benchmark policy rate to reach 2.75% by the end of the third quarter. This is some way below the market consensus and should help the UK economy and businesses in a tough period.

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Importantly, monetary easing should also help counter the effects of any fiscal tightening from the Budget. Their diverging economic impacts mean we expect UK growth to remain broadly stable across 2025 and 2026, at around 1.3%.

Gilt complex

Falling interest rates also underpin our preference for Gilts within developed market sovereign bonds. We think Gilts could offer one of the most attractive combinations of income and capital gains in the coming year, and favour 5-to-7-year maturities. Gilts offer a higher yield versus US Treasuries and German Bunds. This has been driven in part by a higher term premium – the compensation required by investors for holding longer dated debt maturities – due to rising fiscal uncertainties. However, if the Budget does deliver the expected tax rises, these could help ease market concerns over fiscal sustainability and allow the term premium to normalise.

We think Gilts could offer one of the most attractive combinations of income and capital gains in the coming year

In addition, the BoE, which has been selling Gilts since mid-2022, is now slowing the pace at which it shrinks its balance sheet, which could also lift pressure on bond markets. This, in combination with larger than expected policy rate cuts, should help push yields lower. We expect longer maturities to benefit more from the fall in interest rates, and to deliver stronger price returns.

Despite a complex macroeconomic backdrop, we now adopt a more neutral view on UK stocks, as we no longer expect them to underperform among developed markets. The UK offers one of the highest dividend yields, close to 3.5%, with one of the lowest valuations, while 2026 could also see a modest earnings recovery driven by margin expansion and interest rate cuts after three difficult years.

We like the exposure of the UK index to healthcare and utilities companies, combined with some attractively-valued financials and better prospects for the materials and energy sectors. Although UK stocks are under-owned by investors, we believe the index looks well positioned for a rotation into dividend and quality stocks going into 2026. For now the modest earnings rebound and fragile political and fiscal situation prevent us from adopting a more positive view.

For the year ahead, we expect some further depreciation of sterling against the currency of its largest trading partner the euro area, as the BoE lowers interest rates. Over the coming 12 months we assume the euro will move higher against the pound to reach EURGBP 0.92, which would represent the cheapest sterling level in the post-Brexit era.

We expect some further depreciation of sterling against the currency of its largest trading partner the euro area

Given that we expect modest US dollar depreciation in 2026, we expect sterling to strengthen marginally against the dollar to reach GBPUSD 1.33, although the currency pair should remain volatile. Sterling could face further downside risks if fiscal sustainability risks resurface, but given the belt-tightening we expect from the Budget, this is not our core scenario.