The Office for National Statistics has confirmed what the markets had already priced in: the UK economy contracted by 0.3% in the final quarter, as the outbreak of war between Iran and a US-led coalition sent shockwaves through global supply chains and financial markets. The Chancellor is now scrambling to stave off a full-blown recession, but the fiscal arithmetic looks bleak.
Gilt yields spiked to 4.7% this morning as investors fled to safe havens, only to reverse course as the Bank of England signalled emergency liquidity measures. The pound has tumbled to a two-year low against the dollar, and capital flight is accelerating. This is not a garden-variety downturn; it is a geopolitical shock compounded by years of fiscal incontinence.
Let’s be clear: the war in Iran has disrupted oil supplies, pushing Brent crude above $120 a barrel. Petrol prices at the pump are already up 15p a litre, and businesses are passing on costs. The manufacturing PMI fell to 47.2, its lowest since the pandemic. Services are not far behind. The consumer, already squeezed by inflation that remains above 6%, is now cutting back on discretionary spending. Retail sales figures due next week will likely confirm the worst.
But the real problem is the government’s capacity to respond. With public sector net debt at 98% of GDP, the Treasury has little room for meaningful stimulus. The Chancellor has hinted at a VAT cut, but that would only add to the borrowing requirement. Markets are watching the OBR’s next forecasts with a hawkish eye. Any sign of profligacy will be punished with higher gilt yields, squeezing private investment further.
The Bank of England faces an impossible trilemma: support growth, control inflation, or stabilise the currency. It cannot do all three. Governor Bailey has signalled a pause in rate hikes, but that risks fuelling inflation expectations. The Fed is still tightening, which means sterling will remain under pressure. Imported inflation will continue to erode real incomes.
What does this mean for the average investor? The FTSE 250 has already lost 8% this month. Defensive stocks are the only refuge, but even utilities are feeling the pinch from rising input costs. The property market is freezing, with mortgage approvals dropping by a fifth year-on-year. The carry trade is unwinding, and emerging markets are sucking capital out of London.
The Treasury is bracing for a technical recession defined as two consecutive quarters of contraction. But official definitions hardly matter when businesses are laying off staff and household savings are being depleted. The war in Iran has exposed the fragility of an economy built on cheap energy and cheap money. The era of low inflation is truly over.
The only silver lining is that the crisis may force a long-overdue fiscal consolidation. The government should cut spending, not raise it. But that is a political fantasy. The likely outcome is a half-hearted fiscal stimulus that does little to boost growth while frightening the bond markets. Stagflation is the new normal.
In summary: the UK economy is contracting, the Treasury is out of ammunition, and the Bank of England is caught between a rock and a hard place. The Iran war is a catalyst for a correction that was always coming. Brace for volatility.
