The UK economy expanded by 0.6 per cent in the first three months of 2026, following a sluggish second half of 2025 (chart 1, source ONS). Growth was broad-based across sectors with services, manufacturing and construction all expanding over the quarter.

The data point to a solid quarter for manufacturing and services – both of which expanded by 0.8 per cent in Q1. Across services, there was a solid expansion in both consumer, and non-consumer facing sectors (0.7 and 0.8 per cent respectively). Construction, which had a particularly weak end to 2025, also saw a recovery in output at the turn of the year, expanding by 0.4 per cent. Also positive, was a rebound in business investment, which rose by 0.7 per cent, up from a fall of nearly three per cent in previous quarter.

The pickup in activity was consistent with improving business surveys over the quarter, with private sector confidence picking up ahead of the start of the Middle East conflict. Prior to this there were good reasons for firms to be feeling a bit brighter about the outlook. Inflation was heading lower, real wages were set to pick up, and borrowing costs had fallen and were expected to be cut further. Some sources of international uncertainty, namely US tariffs, had settled somewhat and we didn’t have another fiscal event to worry about in the spring.

Headline inflation dropped back to 2.8 per cent in April, the lowest level since last March (chart 2, source ONS). The fall was largely anticipated as a lower energy price cap for households kicked in that month. This change alone lopped nearly 0.5 percentage points off headline CPI. This also accounts for the different trajectory of inflation in the UK versus European counterparts, where consumer prices have accelerated since the start of the Middle East conflict.

The fall in utilities prices also pushed services inflation down to 3.2 per cent, a rate not seen since the start of 2022 (before the Russian invasion of Ukraine). Also positive, however, was the drop in core inflation (excluding food and energy) to 2.5 per cent – that was the lowest since July 2021.

However, and possibly a sign of things to come, transport services made the largest contribution to CPI since the end of 2022, driven by the increase in petrol prices since the beginning of March. While oil prices have eased back a little at the end of May, transport costs are likely to contribute to higher inflation in the months ahead. But more significantly, a new energy price cap has been announced for July. Average household bills are expected to rise by around 13 per cent, which will keep inflation well above target for the rest of the year.

Services activity contracts in May

After solid growth in Q1 activity in the service sector has wobbled since the start of the conflict. The S&P Global PMI is estimated to have dropped back sharply in May and back into contractionary territory for the first time since April 2025 (chart 3, source S&P Global).

Demand from both businesses and consumers dwindled amidst concerns about impact of the Iran conflict and rising inflation, with some respondents noting weak demand for international travel. Cost pressures also rose amongst services firms.

In contrast, the index for manufacturing in May posted the strongest reading since May 2022 reflecting strong output growth as well as a six-month run of growth in new orders from both domestic and export customers. However, the story behind the positive numbers was similar to April – customers front-loading orders due to concerns about higher prices and potential supply chain disruptions. The underlying picture for manufacturing is, therefore, likely to be somewhat more fragile.

Solid uptick in lending to SMEs

As the private sector seemingly had a decent start of 2026, so we also saw a rise in lending to small- and medium-sized businesses (chart 4, source Bank of England). The latest Bank of England data indicate a fairly sustained rise in new lending since early 2024 and in the most recent quarter gross lending was 14 per cent higher than the same quarter a year ago – the largest increase since the end of 2024.

While this feels slightly surprising against the backdrop of heightened geopolitical concerns, it is consistent with stronger activity indicators, improving business sentiment post-last year’s budget and (pre-conflict) the potential for a more stable demand outlook. It is also tallies with the Bank’s Credit Conditions Survey, which has noted a clear improvement in responses balances across the supply of and demand for finance from SMEs.

In addition, it also matches what UK Finance has seen in our data from the main high street lenders. In the second half of 2025 our data reported a solid expansion in approvals for new finance facilities, particularly loans. And this growth was especially marked amongst approvals to the smallest businesses. Our data covering the first quarter of this year will be released in our Business Finance Review on 11th June.

There’s always a but. While we see a positive direction of travel over the past couple of years, in real terms the stock of outstanding lending to SMEs is over a fifth lower than in 2012, when the Bank started to collect this data. We might also expect to see some pull back in Q2 as businesses assess the impact of the Iran conflict – this could take the form of a shift towards finance focused on cashflow management, or SMEs deciding not to proceed and drawdown facilities that have been approved.

Government borrowing costs ease

Rising inflationary concerns and expectations that the Bank of England would have to pull the trigger on rate increases this year have pushed up government borrowing costs, as measured by the benchmark 10-year gilt yield (chart 5, source Investing.com). For most of May gilt yields have been hovering at or above five per cent – the highest level since the financial crisis.

The rise in May coincided with particularly elevated oil and gas prices, reflecting market concern about the limited progress on ending the conflict and reopening the Strait of Hormuz. It also coincided with increased domestic political uncertainty following the Labour party’s (expected) poor showing at the local elections and pressure on Prime Minister Starmer to set a timeline for stepping down.

At the end of the month (and at time of writing) gilt yields had retreated back toward 4.8 per cent. While the political noise has died down a bit, for now, a bigger factor in the move is the easing in the oil price as well as the weak activity and labour market data that has been released over the month – as discussed above. As we see similar movements in bond yields across Europe, for now at least international inflation risks seem to be the dominant driver of bond markets in the UK.