5 August 2026: Can John Healey find the cash to fund his defence ambitions?

The UK economy has shown resilience despite disruption from the conflict in the Middle East. It is now forecast to grow at a slightly better-than-expected pace in 2026, according to EY's new UK Economic Outlook. This should be considered a snapshot of the current situation, which will doubtless change over the course of the year.

The Outlook forecasts UK GDP growth of 0.9% in 2026, a slight increase from the 0.8% projected in May.

GDP growth is then expected to rise to 1.2% in 2027, in line with the firm's previous forecast.

Economic performance in the second quarter of 2026 was better than anticipated, as oil prices returned to pre-conflict levels more quickly than expected, preventing a larger rise in inflation.

Clouds on the horizon include Trump's continued flip- flopping, which is creating uncertainty over peace negotiations with Iran. The U.S. President often makes comments to the media, presenting what he wants to happen as fact, only for Tehran to deny them.

The recent escalation of the conflict, disruption in the Strait of Hormuz, and the subsequent impact on energy prices and inflation are projected to weigh on growth towards the end of the year. At the same time, a prolonged closure could cause the UK economy to contract next year.

The Outlook's baseline forecast assumes the Strait of Hormuz reopens by the end of the current quarter, albeit with subdued tanker traffic.

However, if the conflict escalates and the strait remains closed until early or mid-2027, the Outlook's model suggests UK GDP growth could fall to 0.5 per cent this year and contract by 0.2 per cent in 2027.

If the Strait of Hormuz reopens in Q3, UK inflation is forecast to rise to 3.5% by the end of the year.

However, if the strait remains closed until at least early 2027, there is a risk that UK inflation could rise to 6.5% by the end of 2026.

EY expects the Bank of England to hold the Bank Rate at 3.75% for the rest of 2026 under current conditions. Any further escalation may prompt the Bank of England to consider rate hikes even as a bout of stagflation begins.

In June, new Chancellor John Healey resigned as defence secretary, telling the then Prime Minister in no uncertain terms that he and the Treasury were “unable or unwilling to commit the resources” needed to “defend the country at this time of rising threats”, and that this was wholly unacceptable to him.

He argued that plans to raise defence spending were too slow and too vague, and called for a clearer commitment to spend 3% of GDP on defence by 2030.

Now, under the new regime, Healey no longer has to push the case for higher defence spending; he just has to find the cash to pay for it.

Under the Defence Investment Plan (DIP), the Government will pledge to increase defence spending to 2.7% of GDP from 2027-28; however, in the current environment, this is also a moveable feast, given that by the end of the year, the economy could be in recession, something that Starmer and Reeves never considered when pledging.

This marks the first step towards its commitment to spend 3% of GDP on defence in the next parliament, rising to 3.5% by 2035. Achieving the initial increase is itself a major commitment: the Government has allocated an additional £15bn to the DIP over the next four years.

Big banks and energy giants have announced another wave of eye-watering profits over the past week, fuelled by the ongoing war in the Middle East.

As companies cash in on what one critic dubbed a “war bonus”, ordinary households are paying the price through higher prices for everything from energy and fuel to food in the supermarket.

There are renewed calls for the Prime Minister and Chancellor to impose a windfall tax on these firms, especially banks, on what are considered their excessive profits. However, economists view the picture differently when windfall taxes are mentioned. What is considered the ‘rightful’ amount of profits that banks should make? What happens in ‘down years’, when banks will say that profits from previous years provide them with a cushion?

Labour MPs doubtless consider banking as the City’s equivalent of ‘shooting fish in a barrel’, but there is obviously far more to it than that.

Taxation of banks is a subject that John Healey will need to look at, using the specialist knowledge of his colleagues at the Treasury and the Bank of England to decide what is fair and just.

Sterling’s pullback yesterday was modest and driven by global factors, yen intervention and U.S. rate expectations, rather than by domestic weakness. The currency remains supported by improving UK political clarity and a lower risk premium, but near-term direction will hinge on U.S. data and ongoing FX intervention dynamics.

Fed Chairman Kevin Warsh has been overhauling the Central Bank’s forward-looking communication since taking the post in May. That move has sounded the alarm among market participants, whose investment theses rely, in part, on predicting what the Fed will do with interest rates, previously based on the often oblique clues provided by its Chairman and members of the FOMC.

The Chairman is supposed to provide a mix of his own opinions and a read on the FOMC's mood, while Regional Fed Presidents and Board Members report on what is happening in their regions. That is the theory, although under Jerome Powell the edges had become somewhat blurred.

Fund managers have made a pretty good business out of decoding Fedspeak, the jargon-heavy communication preferred by previous Central Bank Chairmen. Now the Fed has just said it was ‘going to go dark’ on them.

This week, several fund management firms that manage exchange-traded funds tied to inflation and U.S. Treasuries released “WarshGPT.” An artificial intelligence-powered tool that parses nearly 1,800 documents and transcripts from Warsh to help users understand how he may analyse issues related to the economy or monetary policy. It is hard to imagine a world in which using an AI-based model would be considered preferable to good old Fed guidance.

AI-related developments could be driving around one-third of America’s economic growth.

That’s according to a Wall Street Journal report yesterday, which cited three factors behind this trend.

First, tech companies are spending and borrowing billions of dollars to meet their AI computing needs. Secondly, a wave of data centre projects is fueling construction spending, hiring and municipal revenues. Finally, an AI-related stock market rally has increased household wealth, helping to drive consumer spending.

Without this investment boom, the economy would clearly be running cooler. This touches on an age-old argument about innovation and its use in commerce and industry.

“It’s very much an AI-driven economy right now,” added Barclays economist Jonathan Millar. “It’s hard to imagine that we would be anywhere near as resilient without that impetus.”

The report also noted that AI could be consuming so many resources that it has begun to crowd out other areas of the economy. For instance, the land, materials and construction used for data centres might be put to use elsewhere, such as housing, but money always follows where the best returns are, and for now that is in AI and data centres.

There is not so much being made currently about the AI bubble bursting, since it has become something of a ‘self-fulfilling prophecy’. Of course, the more AI is implemented, the bigger the crash could be. There are worrying reports about Anthropic's powerful AI tool ‘going rogue’ in testing; they are the AI equivalent of ‘monsters under the bed’.

In the real world, many economists and market participants view Kevin Warsh’s inflation strategy as a cop-out, because he insists that inflation must fall while refusing to outline or execute the policy actions needed to achieve it. The criticism is grounded in his public statements and the market reaction.

Warsh’s approach is widely criticised for talking tough on inflation while avoiding commitment to rate hikes, guidance, or a clear strategy, instead suggesting that markets should tighten conditions on their own. This has raised concerns about credibility, political pressure, and policy paralysis.

Many feel that if conditions are tightened by ‘market forces’ to the point that a hike becomes unavoidable, Warsh will not face criticism from the President, since Trump has stated that the U.S. should have the lowest borrowing costs in the G20.

In a press conference, Warsh said rising long-term yields “provided us some comfort” and that “markets have done quite a bit,” implying the Fed need not act. Bond markets then reacted sharply, interpreting this as an abdication of responsibility.

It is a fact that, no matter how much or how little Warsh and his colleagues say, they will always be an undisputed market driver.

The USD’s performance yesterday was muted and slightly weaker, driven by lower yields, improving geopolitical sentiment, and softer U.S. data. Markets are now focused on ADP employment and Friday’s nonfarm payrolls, which will determine whether the dollar breaks out of its current tight range.

ECB analysis suggests the war in Iran hit consumption before households in the Eurozone suffered a direct income shock, exposing how fragile the recovery remains when confidence turns.

The Eurozone’s hoped-for consumer recovery comes with a geopolitical warning label. An ECB analysis published earlier this week found that consumption growth fell to about 2.5% in April, down from a previous range of 3% to 4%, as the war in Iran affected confidence and spending behaviour.

Reuters reported the ECB's findings, and the Central Bank’s related analysis was included in its Economic Bulletin. The caution is important: the figures concern April, not real-time August consumption. They remain significant because they show how quickly geopolitical stress can affect household behaviour.

The decline was reportedly twice as large as historical patterns would suggest, with higher-income households cutting discretionary purchases. That is precisely the group often expected to support services spending when lower-income households are squeezed, as has been seen in the U.S.

Eurozone factory output surged at its fastest pace in nearly four-and-a-half years in July. Still, growth was largely driven by firms clearing backlogs rather than rising demand, pointing to a fragile recovery, according to a survey.

The final S&P Global Eurozone Manufacturing PMI rose from 51.4 in June to 51.9 in July, its highest level for three months. Germany recorded the greatest improvement among the largest economies covered, while Poland recovered most of June’s sharp fall.

France returned to contraction, Italy lost momentum, and Spain moved only marginally above the 50.0 no-change threshold, with output and orders still falling in both France and Spain.

Chris Williamson, Chief Business Economist at S&P Global Market Intelligence, said, "Eurozone factories are enjoying something of a summer growth spurt, with production rising at its fastest rate for four and a half years. However, there are signs that this good news may prove short-lived, with momentum at risk of fading as autumn approaches."

The U.S. is adopting and scaling AI much faster than differences in management practices, firm structure, digital readiness, and regulatory environments do in the Eurozone, driving the gap. The result is a widening productivity divergence.

Worker and firm surveys from 2025–26 show substantially higher AI adoption in the U.S. than in Europe. U.S. firms have adopted AI earlier and more broadly, mirroring the earlier ICT revolution, in which American companies invested more aggressively in digital tools. Europe shows wide internal variation: Sweden and the Netherlands are far ahead of Italy or France.

Research finds that management quality explains a large share of the AI adoption gap. U.S. firms tend to have flatter hierarchies, stronger performance-based incentives, and a greater willingness to reorganise workflows. These practices make it easier to integrate AI tools quickly. Many European firms are slower to reorganise processes, limiting AI’s productivity impact.

The euro’s performance yesterday was muted and slightly weaker, driven by softer Eurozone data, cautious ECB expectations, modest dollar firmness, and yen‑supportive intervention.

The common currency remains range‑bound, with upcoming Eurozone PMI releases and U.S. labour data likely to determine whether EUR/USD breaks out of its current consolidation.

Have a great day!