UK Stock Market Rally Meets the "Budget Test"! Tax Hikes, Gilt Yields, and Consumer Pressure Rattle Market Nerves

Title context: UK Stock Market Rally Meets the "Budget Test"! Tax Hikes, Gilt Yields, and Consumer Pressure Rattle Market Nerves Text: Since the start of the year, the UK's FTSE 100 and FTSE 250 indices have risen 8% and 9% respectively, both outperforming the 5.6% gain of the Euro Stoxx 50. Since the start of this month, UK large-cap stocks have been particularly strong, powered by strength in energy, consumer staples, and healthcare sectors, which together account for about 40% of the FTSE 100's weighting. Meanwhile, lower valuations and more stable UK gilt yields have boosted mid-cap stocks. However, just as global investors are turning bullish on the UK market again, the Autumn Budget to be announced this Wednesday will be a major test for the country's stock market. At that point, the bond market's "punishers" will assess potential tax hikes or consumer support measures, weighing these against the UK government's limited fiscal headroom. Autumn Budget Expected to Be Market-Friendly, but Risk-Reward Varies Across Sectors The UK Burnham government will unveil the Autumn Budget on October 28. After the previous chancellor raised taxes by more than GBP60 billion (about USD80 billion) cumulatively across two budgets, current UK Chancellor John Healey has no intention of rolling out another large-scale, headline-grabbing fiscal package. Several phrases Healey and his Treasury officials have repeatedly used recently"do no harm," "stay the current course," and "focus on priorities"appear to have set the tone for the upcoming Autumn Budget. It is understood that Healey will fund a short-term spending plan aimed at courting public opinion by raising bank taxes, to help voters and businesses under pressure from energy costs driven up by the US-Iran war. The Autumn Budget will also include a series of measures aimed at reducing regulatory burdens on businesses, such as simplifying corporate reporting requirements; the government will also extend import tariff suspensions for products in several sectors, including chemicals, plastics, and hydrogen. At the same time, key issues such as welfare reform and long-term investment in defense will be deferred. The market expects that this Autumn Budget will not feature large-scale policy adjustments, and may mainly provide support to households and businesses through reallocating spending. The core of the budget lies in whether it can strike a balance between maintaining fiscal credibility, supporting economic growth, and avoiding further damage to consumption. If the UK government proposes a credible fiscal plan that both stabilizes public finances and avoids a clear hit to consumption, UK gilt yields could fall and the equity risk premium could narrow. But if the UK government cannot convince investors that public finances are sustainable, or if budget measures exacerbate inflation, financing, and consumption pressures, long-term gilt yields could continue to rise and limit the continuation of this rally in UK stocks. Citigroup strategists led by Beata Manthey said: "We believe there is a tactical case for the FTSE 100 to outperform, because UK stocks can effectively hedge GEO Group Inc political risk. However, over the medium term, we remain underweight the UK market in global portfolios." Citi economists expect the UK government to deliver a market-friendly budget that prioritizes maintaining fiscal credibility. But the bank's sector analysts believe risk-reward varies across sectors. For example, UK utilities face disproportionate downside risk. If the government makes energy affordability a priority, it could drive structural reforms whose potential impact the market may not yet have fully priced in. Citi analysts said UK housebuilders are being pulled in two directions: on one hand, the new "Your First Home" scheme could boost demand; on the other, persistently high UK gilt yields are weighing on housing affordability. For banks, this budget could be a key moment for removing uncertainty. Analysts said the market has largely priced in the possibility of raising the bank surcharge, and the reaction of the UK gilt market after the budget is announced may be the more important factor affecting bank sector valuations. On a book value basis, a clear gap has already emerged between UK banks' valuations and their return on equity, and this gap is more pronounced than elsewhere in Europe. This suggests that despite higher ROEs at UK banks and widening sovereign bond spreads on the continent, investors may still demand a higher risk premium from UK banks. In addition to paying 25% corporate tax, UK banks currently also pay a 3% bank surcharge and the bank levy. Goldman Sachs Group, Inc. analysts noted that each 1 percentage point increase in the UK bank surcharge is expected to drag on Barclays PLC Sponsored ADR (BCS.US) 2028 net profit expectations by about 0.5%; for Lloyds Banking Group plc Sponsored ADR (LYG.US) and NatWest Group Plc, the drag on 2028 net profit expectations would be slightly more than 1%. Goldman Sachs Group, Inc. strategists led by Sharon Bell said: "Raising the bank surcharge would have a significant impact. After the budget is announced, the key to driving a valuation re-rating will be whether the UK-specific risk premium can decline and whether market confidence in the UK economy can strengthen." In addition, after the budget is announced, the next major risk event will be the Bank of England's interest rate decision on November 5. The market has almost fully priced in a rate hike, and this would be the first of four hikes the market expects the central bank to deliver by the end of July next year. Such a series of rate hikes would deal a severe blow to consumers and push up mortgage costs for many households. It is therefore unsurprising that UK consumer confidence suffered its largest decline this month since the COVID-19 pandemic. This puts the retail sector at risk, especially if the budget fails to provide substantive support. UK Stocks Regain Favor In October, UK stocks benefited as global investors shifted portfolio allocations toward more defensive assets. According to Morningstar data, UK large-cap exchange-traded funds (ETFs) have attracted an estimated USD3.4 billion in net inflows since the start of 2026, the highest annual level since 2020. Investors' renewed vote of confidence in the FTSE 100 partly reflects their desire to invest in some of the strongest companies on the London market, such as HSBC HOLDINGS (HSBC.US), BP p.l.c. Sponsored ADR (BP.US), Shell (SHEL.US), and Rolls-Royce Holdings. Morningstar analyst Michael Born said: "Investors are looking at the UK market with fresh eyes. Passive fund inflows typically follow market performance, but this also reflects investors' desire to diversify away from US mega-cap tech and further broaden their equity allocations." Inflows into UK large-cap ETFs hit highest since 2020 Meanwhile, according to a fund manager survey released by Bank of America Corp earlier this month, investors are currently net underweight UK stocks by 26%, down from a net underweight of 35% in September. However, this level is still 0.8 standard deviations below the long-term average, meaning investors still have room to further increase their UK equity exposure. However, one of the main potential threats to the outlook for UK large-cap stocks is the oil price. The Middle East war has kept Brent crude above USD100 a barrel, and the energy sector is the main driver of FTSE 100 earnings growth. As analysts expect oil prices to fall next year, the market forecasts FTSE 100 earnings per share growth will slow to just 5% in 2027, compared with an estimated 30% in 2026. Nevertheless, UK equity valuations remain inexpensive, which may provide some buffer for both large-cap and mid-cap stocks. The FTSE 350 trades at a 30% discount to global stocks, remaining one of the key attractions of the UK market. UK stocks are not only a low-cost way to diversify exposure, but the UK is also one of Europe's most active markets for M&A activity, especially in the mid-cap space. The HSBC strategist team led by Duncan Toms said: "The market widely expects UK economic policy to remain relatively stable and the budget to be market-friendly, which limits the upside for the FTSE 100, especially if the budget's main impact is a stronger pound." The team maintained an overall neutral stance on the UK market and said: "By contrast, UK mid-caps look more attractive. In recent months, UK economic activity data have continued to beat expectations, driving the FTSE 250 to outperform. We believe this trend is likely to continue."