The war in Iran has meant domestic politics has largely taken a back seat for the last couple of months. However, political risk jumped back up the agenda last week and is only likely to intensify if the local elections on Thursday go as badly for the Government as expected.

For the economy, the prospect of a leadership challenge is yet another source of uncertainty for businesses and households that could prompt them to put off investment and spending. What’s more, financial markets would likely respond by pushing gilt yields higher as any successor is likely to be more spendthrift than Starmer and Reeves, raising borrowing costs across the economy. The risk is that a messy leadership contest, which causes another round of speculation about tax hikes, potentially followed by another budget would compound the drag on growth from higher energy prices and tip the economy further into stagnation.

Leadership challenge delayed, not cancelled

Prior to the outbreak of war in Iran, it had been an odds-on bet that Prime Minister Starmer would face a leadership challenge in the first half of this year. However, the war seemed to have given Starmer a stay of execution for a couple of reasons. First, his refusal to join the US/Israeli strikes on Iran boosted his polling. Second, it seems unlikely that any would-be new PM would want to take over the reigns during an international crisis – or that the labour party would support the timing of such a move. It is worth remembering that it is much more difficult for the labour party to change leaders than it was for the conservatives, requiring more of a consensus.

That doesn’t mean that Starmer is out of the woods, though. The recent controversy about the appointment of Peter Mandelson has caused the odds of a leadership challenge to jump again. What’s more, polls suggest the government is set to lose heavily in the local elections on Thursday, potentially losing 50% -75% of its council seats. A result close to that would further fuel speculation that Starmer will be ousted this year. The final straw could easily be a clash between backbench MPs, who are demanding more support on fuel and energy prices, and the Chancellor, who quite rightly says bond markets would punish further borrowing. Indeed, even Karl Turner, one of Ms Rayner’s more outspoken backers, recently said ministers must abandon the idea that “we are somehow slaves to the bond markets”, echoing similar comments by Mr Burnham last year.

According to betting markets, any leadership challenge is more likely to come in the second half of the year rather than before June. That makes sense to us given the ongoing conflict in Iran and that there is not, yet at least, an heir apparent.

But that just means the economic consequences of a leadership challenge are delayed rather than cancelled.

Domestic politics could further dampen the outlook this year

There are a few risks to the economy from a change of leadership. First, in the near-term, speculation over when Starmer will be replaced would be enough to raise uncertainty and dampen activity by itself. Second, a messy leadership contest that opens Pandora’s box of potential tax hikes would raise uncertainty even further, potentially prompting firms to cut back on investment and households to ramp up savings. Indeed, speculation at the last two Autumn budgets about tax increases dampened growth in the second half the year. In H1 2024 and 2025, growth averaged 0.7% and 0.4% respectively before slowing sharply to 0.3% and 01% in H2.

Second, whoever replaces Sir Keir is likely to want to spend more. The front runners are currently Angela Raynor and Andy Burnham, both of whom have indicated that they would favour a more interventionist approach to the economy and would like to see government spending rise further. This has raised red flags among gilt investors and is one reason gilt yields – the cost of government borrowing – have risen above 5% for the first time since 2008.

Granted, more debt funded government spending would, in theory, provide a near-term boost to growth, but it would also boost inflation. That would likely cause the Bank of England to hike interest rates and would send gilt yields soaring. That increase in borrowing costs would largely offset the positive impact from an increase in government spending.

Admittedly, even if Sir Keir Starmer stays on as Prime Minister, the government will face greater pressure to support households and businesses with energy bills if there is not a permanent solution to the conflict in the Middle East soon. This suggests more near-term spending and higher gilt yields in the coming months regardless of who is in charge.

Ultimately, there is a growing risk that the UK lurches from an energy crisis straight into a political crisis which results in another bout of uncertainty and even higher borrowing costs. This would almost certainly ensure that 2026 is another year of stagnation for the UK economy and increase the likelihood of the economy slipping into a recession.

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