UK’s Renewed Appeal Runs Into a Tough Budget Test

Meanwhile, cheap valuations and more stable gilt yields have boosted mid-caps. But the stakes are high heading into Wednesday’s budget, when bond vigilantes will evaluate potential tax hikes or consumer support measures against the government’s limited fiscal headroom. “We see reasons for tactical outperformance for the FTSE 100, as the market serves as an effective geopolitical hedge,” said Citigroup Inc. strategists led by Beata Manthey.

“We nevertheless remain underweight UK globally over medium term.” The bank’s economists expect a market-friendly budget that will prioritize fiscal credibility. Citi’s sector analysts, on the other hand, see varied risk-reward across industry groups. UK utilities, for one, face disproportionate downside risk, as the government’s focus on energy affordability could bring structural reforms that the market may be under-appreciating.

UK homebuilders sit between a potential demand boost from the new “Your First Home” program and affordability headwinds from elevated gilt yields, Citi analysts said. For banks, the budget could be a potential clearing event. An increase in the tax surcharge on lenders looks largely priced in, while the gilt market’s reaction to the budget is arguably a bigger driver of sector valuations, they said.

UK bank valuations based on book value have opened a significant gap to their return on equity, a gap that’s more pronounced than it is in the rest of Europe. That’s a sign that investors are likely applying a greater risk premium to British banks, despite their higher ROE and rising sovereign spreads on the continent. UK lenders already pay a 3% banking surcharge on top of the 25% corporation tax, as well as a bank levy.

According to Goldman Sachs Group Inc. analysts, each percentage point increase in the UK banking surcharge would equate to a drag of about 0.5% on 2028 net income estimates for Barclays Plc, and slightly over 1% for Lloyds Banking Group Plc and NatWest Group Plc. “An increase in the bank surcharge would be significant,” said Goldman strategists led by Sharon Bell. “For there to be a re-rating post the budget, the key will be a reduction in UK-specific risk premium and a rise in confidence about the UK economy.”

Once the budget is out of the way, the next major risk event is the Bank of England rate decision on Nov. 5. An interest-rate increase is almost fully priced in, the first of four expected by the end of July next year. A series of hikes like that would be a serious blow to consumers and raise mortgage costs for many households. It’s no wonder then that UK consumer confidence this month fell the most since the Covid pandemic.

That puts the retail sector at risk, especially if the budget fails to provide meaningful support. The UK market has benefited from a flip in global investor positioning in October, characterized by a move to more defensive assets. According to the Bank of America Corp. fund manager survey out earlier this month, investors are now net 26% underweight UK equities, compared with a net 35% underweight in September.

That is still 0.8 of a standard deviation below the long-term average, leaving scope for more exposure. Meanwhile, UK large-cap exchange-traded funds have attracted $3.4 billion in estimated net inflows in 2026, their strongest annual total since 2020, according to Morningstar data. The renewed vote of confidence in the FTSE 100 partly reflects investor appetite for exposure to some of the London market’s strongest names, like HSBC Holdings Plc, BP Plc, Shell Plc and Rolls-Royce Holdings Plc.

“Investors are looking at the UK with fresh eyes,” said Michael Born, an analyst at Morningstar. “Flows into passive funds typically follow performance, but they also reflect investors looking to diversify away from US mega-cap technology and broaden their equity exposure.” One of the main potential threats to the outlook for UK large caps is oil prices. The war in Iran has kept Brent prices above $100 a barrel and it’s the energy sector that’s driving most of the earnings growth for the FTSE 100.

With analysts pricing lower oil prices next year, earnings-per-share increases are projected to fall to just 5% in 2027, compared with 30% in 2026. That said, valuations remain undemanding and may provide a cushion for large and mid-caps alike. The FTSE 350 offers a 30% discount to global stocks and remains among the main attractions of the UK stock market. Not only is it a cheap way of diversifying exposure, but it’s also the most fertile ground for M&A in Europe, especially when it comes to mid-caps.

“Widespread expectations of relatively stable economic policy and a market-friendly budget limit the upside for the FTSE 100, particularly if such a budget were to manifest itself primarily in a stronger pound,” said HSBC strategists including Duncan Toms. They retained a neutral stance overall on the UK. “Instead, UK mid-caps look more attractive. Persistently positive UK activity surprises are driving FTSE 250 outperformance in recent months, which we think can continue.” More stories like this are available on bloomberg.com