UK Economy Update - July 2025

Economic Overview

The UK economy experienced an unexpected contraction in May, with a reported decline of 0.1% in economic activity, contrary to analysts' expectations of a 0.1% growth. Despite a 0.5% expansion in the three-month GDP rate, the disappointing performance in April and May raises concerns about the upcoming June figures and their potential impact on the Q2 GDP rate.

Factors Contributing to Economic Weakness

The decline in May's GDP was primarily driven by a significant drop in production, which negatively impacted GDP by 0.9%. This downturn suggests a lingering 'tariff overhang' despite the announcement of a UK/US trade deal in May. The anticipated quick recovery in UK manufacturing may have been overly optimistic, necessitating a wait until June to assess the trade agreement's benefits.

Key sectors contributing to this weakness included oil and gas, car manufacturing, and pharmaceuticals. While oil and gas extraction was less affected by tariffs, the automotive and pharmaceutical sectors faced challenges. Car exports were subjected to a 25% tariff, which has since been reduced to 10% with an annual quota exempt from tariffs. The pharmaceutical sector is still awaiting clarity on tariff rates, although the trade agreement promises preferential treatment for UK pharmaceutical companies.

Construction Sector Challenges

The construction sector also faced difficulties, with a reported decline of 0.6% in May. The extreme temperatures in June and July may further hinder construction productivity, particularly in regions where weather conditions significantly impact operations.

Market Reactions

Following the GDP report, the British pound continued its decline, trading below $1.3550 against the US dollar. The dollar's strength across the G10 currencies contributed to the pound's underperformance. The recent volatility in the bond market has also diminished the pound's appeal, making it the second worst performer in the G10 this week.

Impact of Tariff Threats

President Trump's recent tariff threats have further dampened market sentiment. He indicated that Canadian exports could face tariffs of up to 35% starting August 1, and suggested potential increases in tariffs for other countries lacking trade agreements. The uncertainty surrounding the EU's tariff agreements adds to the market's cautious tone.

Government and Bond Market Implications

The weak GDP figures place additional pressure on the UK government and the bond market. UK bond yields have shown modest increases, with concerns that two consecutive months of negative growth could lead to downward revisions in growth expectations during the Autumn Budget. This situation complicates Chancellor Rachel Reeves' efforts to maintain fiscal discipline without raising tax rates, as the UK struggles to manage its debt under the current Labour government.