UK tax rises coming, a boon to Gilts

This week’s Spending Review provided investors with a bewildering array of figures, but the big picture for the UK economic outlook, and our positive view on Gilts, is unchanged. Whilst we now have a better understanding of this Labour government’s priorities for the current Parliament, the overall level of expenditure was known beforehand, and remains broadly the same as projected at the time of the Spring Statement (save for a little £1.25bn winter fuel black hole). What it does do, however, is re-focus investors’ minds on the daunting level of spending required to keep the economy functioning; or at least, the level and focus of spending Ms Reeves and Sir Kier hope is sufficient to stem the flow of voters towards Reform.

Heavy spending is clearly unavoidable; structural economic forces weighing on our economy due to ageing demographics, and more recently, the wheels put in motion due to geopolitical factors and the fading of a US presence in Europe’s defence arena, mean that spending increases on areas such as healthcare and defence are critical. The UK’s health and social care bill is set to rise to £246.7bn for fiscal year 2028/29, in today’s prices, whilst defence spending is expected to hit £73.5bn. These are not small sums, and these two categories along with the protected education department, unsurprisingly eat up most of the spending increase. Nor is spending in these areas likely to be particularly growth-stimulative. Whilst health care fiscal multipliers can be fairly high, we struggle to see the full potential of this economic impulse being realised as capital works its way through an inefficient and overwhelmed NHS. Defence spending will help, as it looks like the capital spending portion will receive the largest increase (presumably investment in military infrastructure and new equipment), but the fiscal multiplier of this category is still likely to be low in absolute terms, uncertain and long-term in nature[1].

The capital spending plans of an additional £113bn, focussed on areas such as transport infrastructure, green energy projects and housing are useful from a supply-side perspective. As a reminder, capital investment will not directly impact the fiscal rules but it does still require funding. Serious questions remain whether the additional £140bn of extra borrowing and the associated additional debt interest to be incurred, make this worthwhile[i].

The measures announced this week do not help Reeves with the ever-looming battle against her fiscal rules. The £9.9bn budget headroom which was restored at the Spring Statement already looked worryingly slim. Now, it has already deteriorated due to the reinstatement of the winter fuel payments, but more importantly, Gilt yields are running above the latest OBR forecasts[2], exacerbating the debt interest burden and government budgetary pressures.

Average realised level Q2-to-date (through 12-Jun-2025)[2]

In March, the OBR noted that a 0.6 percentage point increase in Bank Rate and Gilt yield expectations would eliminate the current balance headroom. Whilst realised Gilt yields have not been higher by that magnitude, they are clearly on the wrong side of even. Add to this a reliance on the productivity growth of the UK picking up (why would this abysmal post-GFC trend change?) and global trade headwinds from US foreign policy; it is clear Reeves will not be able to rely on UK growth to pick up the slack, at least in the short-term.

[1] European Commission: The economic impact of higher defence spending, 19-May-2025

[2] Office for Budget Responsibility: Economic and fiscal outlook – March 2025, 26-Mar-2025

A likely consequence of all this is that Reeves will need to act in the Autumn Budget to restore, once again, the headroom to the fiscal rules. After this week’s review, departmental spending plans are locked in for the next three to four years, leaving few areas left for spending cuts, with those available – welfare, for example – likely to cause painful political backlash. Reeves has made clear that a debasement of the fiscal rules is out of the question and as such, tax rises, though technically breaching manifesto pledges, seem to be the only feasible outlet. Stealth tax rises such as a further freeze on income tax thresholds are possible, and it is looking likely that council taxes will rise. These tax hikes would come against a backdrop which sees the UK’s tax burden at the highest level for half a century.

Source: OBR. Dashed portion of the line represents forecasts.

Our view is that further fiscal tightening from here will weigh heavily on an economy which is already stuttering. The post-COVID imbalances in the UK labour market have faded, and National Insurance costs have led to a sharp fall in demand for workers. We believe there are significant upside risks to the unemployment rate and downside risks to wage-growth-led services inflation. As such, we can see a path for the Bank of England to over-deliver the versus the market’s expectations of policy rate cuts, by accelerating the pace of cuts in the second half of this year, and early 2026.

Source: Bloomberg, ONS.

The Gilt curve has steepened considerably since mid-2023 as the probability of recession steadily fell, and as government bond supply concerns have led to rising long-end yields. At this stage, we find the long-end attractive given the combination of the high starting yield offering a decent opportunity for carry, combined with a rising probability of a faster pace of BoE easing, in our view.

Source: Bloomberg, data as at 13-Jun-2025

The fiscal picture is a concern for government bond market investors but ultimately, we believe long term yields will be primarily driven by the trends in economic growth and inflation. The UK is not alone in its dilemma; the passing of Trump’s Big Beautiful Bill through Congress is highlighting the unsustainable path of US debt, whilst Germany’s recently-announced fiscal plans are adding term premium to the long-end of that country’s yield curve. The difference is that the domestic policy and fiscal drag for the UK are more likely to weigh on growth, and the relative value of elevated Gilt yields therefore looks attractive. Whilst Reeves will maintain her “ironclad” fiscal rules, the growth drag from fiscal tightening looks unavoidable which, in our view, can only lead to lower yields in time.

[i] Institute for Fiscal Studies: Spending Review 2025 – an initial response, 11-Jun-2025