Market Update 27th October 2025

Eye of the beholder

The UK budget is almost exactly a month away and much of the narrative around it is negative.

A few days ago, there was a story saying Rachel Reeves might wipe “billions” off the UK equity market if she makes changes to capital gains or dividend taxes. This was followed on Friday by a story saying she was considering increasing income tax, which would break an election promise.

There are a number of possible permutations of the income tax story including not doing it at all, so I won’t dwell on it too much here. I’m not trying to guess or predict what she is going to say.

The point for our purposes is that I think it is reasonable to say that expectations around the budget are very low. An income tax rise would clearly be unpopular with most people, even more so having promised not to.

The last budget was bruising and many of the same problems remain. But if we look at this in the context of financial markets, what tends to move them is the difference between expectation and reality. With low expectations around the budget, there is in my view more chance of a positive surprise. You and I wouldn’t thank them for an increase in income tax, but the bond market might.

UK inflation has been rising again in 2025. CPI is now 3.8% – a similar number to the Bank of England base rate which is 4%. In Europe inflation is 2.2% and base rates are 2.15%.

One reason UK inflation is almost double the EU is the government itself. They have increased labour costs to businesses – firstly through minimum wage increases and secondly by increasing business national insurance contributions. Restaurants and bars, for example, pass these higher costs on to customers through higher prices.

From talking to one of our fund managers this week, I believe there is a belated realisation from the government that they can’t keep creating their own inflation like this and we are unlikely to see further inflationary changes this time.

Like other Western countries the recent rate cycle has caused problems for the UK by increasing its cost of debt. We also hear a lot about this in the press, but how bad is the UK government debt situation?

In the UK the IMF estimates debt to GDP is currently about 101% while in the US it is 123%. Interest expense as a percentage of government revenue is about 10% in the UK and about 15% in the US.

There are some structural differences between the two countries. Firstly, in round numbers UK government tax revenue is a bit less than 40% of GDP and in the US it is a bit less than 30%. The difference is a larger UK welfare state, including the NHS plus some differences around the UK being more centralised versus the US federal system.

Secondly, the UK government has about a quarter of its debt in index linked gilts, while US TIPS are less than 10%, so inflation makes the UK government interest payments more volatile than the US.

This means the US starts from a significantly worse debt position and this contributes to a bigger budget deficit.

One solution that gets airily mentioned is to “inflate away” the debt. This works fine on a spreadsheet but the people doing the voting dislike higher inflation. Look at 2022 and the trouble we had with higher energy bills. Running purposely high inflation to erode the value of the debt is mostly just going to get you unelected long before the debt disappears. I think we can rule it out.

The current government is visibly terrified of the bond market and rightly so. The Liz Truss incident won’t be forgotten for a long time by either party. One way to be less beholden to the bond market is to owe them less money.

This persistent narrative about the poor state of UK finances means I think even now we sometimes forget – or it doesn’t receive much attention – the UK equity market is year to date the third best performing major equity market in local currency. I have China up 34%, Europe up 27% and the UK next with 17%. This is ahead of Japan with its corporate reform story, ahead of the US with its exceptionalism and the mag 7 still dominating headlines, ahead of India with its multi-decade structural growth story.

But as in the US, small caps continue to lag in the UK. Small caps tend to be more domestically focused and more economically sensitive – small changes in borrowing costs can have a big impact for example, as can changes in the minimum wage or employer VAT contributions, or if the government withdraws inheritance tax incentives.

UK housebuilders have risen around 20% over the last couple of months, but this is off a low base after a torrid time over the last year since the last budget. Before the recent rally they were down nearly 40% from last autumn. Housebuilders are a poster child economically sensitive sector, rallying hard into the budget announcement.

UK 10 year bond yields have fallen around 25bps over the last month – a significant move and some of it is specific to the UK. US 10 year yields have fallen only about 10bps in the same period. This has led to 5 year swap rates falling to relative lows, meaning mortgage rates should be coming down – this should help free up spending for UK consumers.

Some of the market moves listed here are maybe small in themselves. But taken together, both the UK gilt and equity markets are telling a different story than the UK newspapers about sentiment in the run up to the budget. Rachel Reeves doesn’t have much to work with – nor would any other Chancellor at this time. But if she is able to beat some very low expectations, we could see UK markets continue to improve.

Robert Fullerton – Senior Research Analyst

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