UK assets are in trouble — and any rewards come with plenty of risk

Economic headlines in Britain have been bleak in recent weeks. The government has a multibillion pound black hole to fill in the Budget on November 26. Meanwhile, the cost of long-term UK government borrowing has risen to its highest level since 1998. Some commentators have even talked about a repeat of 1976, when the UK was rescued by a loan from the IMF. 

Some of this talk is massively overblown. The UK has no problem finding buyers for its bonds at higher yields (a recent gilt auction was oversubscribed tenfold), has no exchange rate peg to defend and thus has no need to turn to the IMF. British government debt has an average maturity of 14 years, so the country can switch to issuing shorter-term debt if long-term costs are high.

While the UK faces fiscal challenges, it is far from unique. Some other developed countries face even deeper problems. Britain currently has a smaller budget deficit (as a percentage of GDP) than the US or France, a lower government debt-to-GDP ratio than Canada, the US, Italy or Japan, and its debt service costs, as a percentage of GDP, are lower than those of Canada, Italy and the US.

Nevertheless, developments in the UK economy ought to cause investors concern. Higher bond yields may be common across the developed world, but they still push up borrowing costs for consumers and businesses. And both equity and bond markets tend to struggle to make progress when borrowing costs are rising.

The UK government will also have to spend more on interest payments, making its Budget calculations even more difficult. The Treasury pays more than £100bn a year in interest — more than it spends on education. As old debt matures, interest costs will rise as the government is forced to pay the higher rates required by the markets. 

The UK’s fiscal position may not be as bad as some others, but its long-term borrowing costs are higher than those of any other country in the G7. The explanation is not hard to find; the UK’s inflation rate, at 3.8 per cent, is also higher than elsewhere in the G7 and investors demand higher bond yields to compensate. So it is possible to imagine a gloomy situation in which the UK gets stuck in a slow-growth, higher-than-average inflation scenario in which neither its bonds nor equities look attractive. 

Some of this is not the UK’s fault. Government bond yields have generally been driven higher around the world this year. Yields on 30-year German, French and Dutch bonds are at their highest since 2011, when the euro crisis was in full swing, while US 30-year bond yields are close to their highest in 20 years. Japanese government bonds used to have a negative yield but now have moved sharply higher. This may have reduced the “carry trade” whereby investors would borrow in Japan and invest in higher-yielding bonds in other countries.

Part of this trend is a return to normal after the low inflation and interest rates experienced in the 2010s. But President Donald Trump’s assaults on the independence of the Federal Reserve, the US central bank, have made investors nervous that inflation might start to trend higher in the long run. When US bond yields head higher, UK yields tend to follow. The same inflationary fears explain why the gold price has repeatedly hit new highs.

To some extent, high UK bond yields are just collateral damage from events elsewhere. Nevertheless, Britain lacks some advantages enjoyed by other developed nations. Japan has a lot of debt, but it has run current account surpluses for decades. It owes its debt to its own citizens. Britain has run consistent current account deficits and still runs a deficit of 3 per cent of GDP. It needs to attract capital from foreigners.

While this is also true of the US, which has a current account deficit of 3.9 per cent of GDP, it is the world’s largest economy and its most liquid government bond market, while the dollar is the premier reserve currency. 

The UK market is also losing two key sources of demand for government bonds. The first is corporate defined benefit pension schemes. These tend to own a lot of government bonds as a way of matching their liabilities (the pension benefits). But most companies have switched to defined contribution pension schemes, where the employee gets a pot of cash on retirement and has to generate their own pension. These retirees have less enthusiasm for government bonds. 

The second missing buyer is the Bank of England, which spent much of the past 15 years purchasing government bonds through its quantitative easing programme. But since 2022, the Bank has been reducing its bond holdings through a process known as quantitative tightening. Over the past year, its stockpile of gilts has fallen by £100bn. Accordingly, the private sector has to absorb not just the bonds the government is issuing to cover its deficit, but also the holdings offloaded by the Bank of England.

With two big domestic bond buyers no longer available, Britain has to work harder than ever to attract foreign investors. And the government feels compelled to meet its fiscal rules, even though it has become clear that substantial cuts to public spending are not acceptable to its backbenchers. That means tax rises are inevitable.

The size of the fiscal hole that Rachel Reeves has to fill (and thus the amount of tax increases required) depends on what assumptions the Office for Budget Responsibility (OBR) makes about future economic growth. Some commentators think the OBR has been too optimistic in the past, particularly about likely improvements in productivity, and thus may have to downgrade its forecasts. 

This dependence on the OBR’s judgment was a reform introduced by George Osborne, the Conservative chancellor of the exchequer from 2010 to 2016. It was designed to give investors confidence that the government was not using overly optimistic economic projections when setting fiscal policy. But it has had some rather bizarre effects.

First, any chancellor must undergo a back and forth with the OBR when making their Budget projections. This unelected body has a sort of veto over government policy. Second, under the government’s fiscal rules, it must aim for a reduction in its debt, as a proportion of GDP, in five years’ time. Given that economists struggle to forecast the economy one year out, this is crystal ball gazing.

It also means that governments can postpone the pain by assuming big cuts in public spending (or tax increases) in four years’ time. By the time that fateful date is reached, such austerity may be politically impossible (and there is a chance that Nigel Farage will be prime minister). But by then, of course, the new fiscal target will be a further five years away.

Unfortunately for the government, the fiscal target means that Rachel Reeves, the chancellor, will have to play Scrooge rather than Santa this year. Some may feel that she has been playing Scrooge ever since the government took office. In fact, while the 2024 Budget is usually remembered for tax increases (such as the rise in employers’ national insurance contributions), these were outweighed by boosts to public spending (including pay increases for many workers). The overall impact, according to the OBR, was a fiscal stimulus of about 1 per cent of GDP.

That may help to explain why the UK economy managed to grow reasonably well, in relative terms, in the first half of 2025, when growth was faster than in the US, for example. But the forthcoming Budget will result in the government taking demand out of the economy. That will create a headwind for economic growth in 2026.

If fiscal policy will be no help to the economy, monetary policy will not be either. With UK inflation almost twice the target level, the Bank of England has little scope to cut interest rates substantially from their current level of 4 per cent. That will not make it easy for UK equities to shine. 

They haven’t shone much since the dotcom boom. At the end of 1999, the FTSE 100 index was a little shy of 7,000, whereas the US’s S&P 500 was just short of 1,500. It took a long time for the Footsie to pass 7,000 and, even now, a quarter of a century into the new millennium, the index has only recently pushed past the 9,000 level. That is a 30 per cent capital gain in 25 years. The S&P 500 has more than quadrupled over the same period.

Contrarians may perk up at such figures: surely that makes UK shares a bargain? However, the best time to buy UK shares was undoubtedly in late 2020, when the FTSE 100 was still below 6,000. The index has risen 50 per cent since then.

Ian Harnett, chief investment strategist at Absolute Strategy Research, says that the poor relative long-term performance of UK shares almost exactly mirrors the poor performance of UK corporate profits compared with those of US companies. UK companies also earn a lower return on equity than the global average and this return is more volatile. This reflects the cyclical nature of many UK companies. They do best when the economy is booming.

When it comes to valuations, Harnett says the UK market is not that cheap in terms of dividend yield or price/earnings ratio when compared with its history. It may look cheap compared with the US, but that is hardly surprising. The US stock market is a global behemoth thanks to its technology giants, which command high valuations. The UK, by contrast, has scarcely any tech stocks. And Harnett points out that UK stocks don’t look particularly cheap relative to other non-US markets.

It is also worth noting that both the FTSE 100 and the FTSE 250 index have a very heavy weighting towards financial stocks; mainly banks and insurance companies. With commentators talking about a possible windfall tax on banks in November’s Budget, that could be a further headwind for UK equities.

None of the above means UK assets lack any appeal whatsoever. The higher rate of bond yields means that gilts offer an attractive income at a time when other savings rates have been falling. Ten year gilt yields seem to have settled into a 4-5 per cent range since the middle of 2023. The UK government looks a lot more stable than that of France, for example, and the independence of the Bank of England (and thus its ability to tackle inflation) is a lot more assured than that of the US Federal Reserve.

But these modest rewards come with plenty of risk and it is hard to envisage a scenario in which UK assets deliver bumper returns from these levels. Buying UK assets might seem the patriotic thing to do but it will not necessarily be the most profitable.