What to Expect From the UK Budget

The UK budget arrives later this month amid competing predictions about growth, inflation and public finances. Andrew Sheets and Bruna Skarica examine how the country’s economy defies expectations.

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Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Global Head of Fixed Income Research at Morgan Stanley.

Bruna Skarica: And I'm Bruna Skarica, Morgan Stanley's Chief UK Economist.

Andrew Sheets: Today, the UK makes a budget. Why it matters? And more generally, what we've gotten right and wrong about the country.

It's Wednesday, October 14th, at 2pm in London.

Bruna, it's great to be here talking with you, and I'd like to get into a bigger discussion on the UK and what we've gotten right and wrong about the direction of the country this year. But more immediately, it has a very big event coming up.

What is the budget, and why is there so much focus on it?

Bruna Skarica: The budget is the UK's key fiscal event. It is the time of year when the Chancellor receives a refresh of economic forecasts and decides whether he needs to respond to these, whether there's any spending cuts or increases that are required, and whether there's any tax hikes or potentially tax cuts that are required too. All with the view of ensuring fiscal consolidation and executing on what is a self-imposed fiscal framework.

Here in the UK, the main target for the Treasury is to achieve current budget balance in year three of the forecast. The fiscal watchdog forecasts five years of economic variables, and the idea is, by the third year, we ought to be spending outside of investment expenditure as much as we're receiving in tax receipts.

So, all of that happens once a year in the budget.

Andrew Sheets: Now, I might just stop you there [be]cause in the context of these other budget pictures that we see around the world – the U.S. is running a large budget deficit, France is running a large budget deficit, Japan's increasing its budget deficit. That actually seems like a quite ambitious goal within the next three years; to balance that outside of the interest expenses.

Can you just talk maybe a little bit more about that process and the thinking behind it?

Bruna Skarica: Yeah, sure. The idea really is to ensure that over the next five years, not only do we get the current budget balanced while allowing for borrowing for investment, which is, of course, a favorable way to borrow because it boosts growth.

But also, that within the five-year period, we're able to get debt-to-GDP ratio down. In order for that to happen, we need to be running a primary surplus around 1.5 percent of GDP.

Now, very often in UK macro, we tend to look at three-year forecasts, five-year forecasts. We talk about medium-term headrooms. But I think it's important here to take stock of where we are at this moment in time.

We think that in this fiscal year, [20]26-[20]27, primary deficit – our entire expenditure outside debt servicing costs minus tax receipts – we see that at just under 1 percent of GDP. The IMF is a little bit above 1 percent of GDP for UK. But for example, the IMF sees French primary deficit at 2.9 percent this year, with the U.S. measure forecast at 4.9 percent.

So already, UK has actually made a lot of progress in its consolidation path.

Andrew Sheets: And Bruna, talking about this announcement specifically, could you maybe talk about just one or two items that you'd be on the watch for as potential surprises? Or decisions that the market is really focused on?

Bruna Skarica: Sure. So, we do know that the Treasury is looking at ways of alleviating some of the pressures stemming from higher inflation, higher energy inflation in particular. So, the scale of support that will be provided to households and the scale of reduction in headline inflation, I do think will be in focus on the day.

We're expecting a relatively low-key budget, so the scale of measures at around £10 billion, which is much more moderate than what we saw in October 2024 and in November 2025.

However, we do think there is scope for some, let's say, higher level announcements. For example, Prime Minister Burnham is particularly focused on devolution in the UK, decentralization. And there might be a roadmap ahead for how different mayors and different regions in the UK get to keep their portion of income tax revenues and what they might do with it in order to boost regional growth.

UK does stand out as the country in G7 space that has the most centralized fiscal system, and this might start to be changed from this fiscal event onwards.

Andrew Sheets: Okay, so now I'd like to take a step back and do a little marking to market.

You know, you and I on this program, a couple of different times this year, have been talking about the UK, and those conversations have generally been upbeat. I think both of us were of the view that the UK could actually be a bit better of a story than expected. And maybe we start with the good news.

What do you think has been going right?

Bruna Skarica: So, for one, growth has outperformed in the first half of the year. In line with our long-standing thesis that UK ought to be a beneficiary of the global AI boom, the main driver of the upside surprise has been the tech sector. It's running at 8 percent year-on-year, this year.

We have also seen a bit stronger consumer spending growth than anticipated. And again, this reflects, we think, our long-standing thesis on fairly clean household. But also corporate balance sheets, I should mention, that tend to provide a fairly big buffer in one of energy shocks.

UK consumers have elevated savings, also elevated savings stocks, and so in energy shocks such as the one we've seen in the first half of the year, perhaps there is some reduction in desired level of savings, which allows consumers to support their spending habits.

All of this means that this year we see UK growth at 1.3 percent. Now, our U.S. colleagues are looking for 2.3 percent. Still, U.S. growth looks relatively stronger than any European country, including the UK.

However, I would say that 1.3 percent is about 30 basis points higher than where we were a couple of months ago when the energy shock started, so it is important to take that into account.

Andrew Sheets: And I'd also note that UK stocks are up about 10 percent this year, and its currency, the pound, is materially outperformed the euro or the Japanese yen.

But Bruna, I think it's pretty safe to say that sentiment towards the UK feels pretty downbeat. I think it's probably gotten worse as the year has gone on.

So, what's gone wrong and what's been worse than we were expecting?

Bruna Skarica: Yeah. So, while I do think that in the U.S. there is a lot of focus on the benefits from the AI boom and the AI build-out, in Europe, we're still waiting to see the sentiment shift towards how much growth and potential growth in particular can benefit from adopting AI.

We're more constructive, I would say, than probably the average forecaster here. We're pointing to healthy productivity growth performance in the UK private sector, printing productivity growth at 1.8 percent; whereas in the U.S. this figure is a bit above 2 percent over the second quarter this year. So, not too different, I would say.

So, I think the pessimism around potential GDP growth is really what's driving the view that whenever an external energy shock tends to hit, such as the one we've seen this year with higher oil and natural gas prices, it'll be embedded in the economy for a longer period of time. Because ultimately a spare capacity is very tight. And so businesses and consumers will try and preserve their real purchasing power, and inflation will remain elevated for a longer period of time.

Again, we tend to be a bit more constructive on this. We think the economy has enough spare capacity for this energy shock to come and go without material adjustments in the bank rate. We're expecting two hikes. But the market is still pricing four hikes. And certainly in conversations with investors, we are more and more talking about the scenarios in which these could be delivered.

So that, of course, means higher gilt yields, which means higher debt servicing costs, and that overall, I do think tends to dampen sentiment.

Andrew Sheets: Well, Bruna, a lot to watch in the days and weeks ahead. And thank you so much for taking the time.

Bruna Skarica: Thank you, Andrew.

Andrew Sheets: And thank you as always for listening. If you find Thoughts on the Market useful, let us know by leaving a review wherever you hear us. And also tell a friend or colleague about us today.