As we approach Christmas there is plenty of unseasonal (yet justified) gloom in the air about the outlook for the UK economy, but the last year has provided a handy lesson in how the economic backdrop and equity market performance can significantly diverge. We could be in store for a continuance of the UK’s market rally, which presents an intriguing opportunity given the domestic valuation discount.
It’s not that UK market fundamentals are particularly strong. From the flailing number of London IPOs to sustained equity outflows, investors have voted with their feet in the midst of a relatively unfavourable tax and regulation landscape and the pull of the tech driven US market. The latest data from Calastone showed outflows from UK equity funds for six months in a row to November, totalling £10.4bn.
Meanwhile, the UK’s borrowing costs are the priciest in the G7 because of concerns over the trajectory of state debt and a pullback in buying from pension funds, and the government’s tax take is at a record high. It’s no wonder economic confidence is weak — the Institute of Directors’ confidence index sits at a near record low. The consensus forecast for UK GDP growth in 2026 is only 1.1 per cent, down from 1.4 per cent this year.
And political ructions present a risk to sentiment on UK assets in the short term. The electoral threat to Labour from the Reform party, currently riding high in the polls, could potentially spell trouble for inflation and rates if the government turns to panicked fiscal expansion in a bid to boost growth.
Despite this backdrop the FTSE All-Share has delivered a total return of 22 per cent year to date, nicely ahead of the MSCI World’s performance in sterling even with the lack of domestic exposure to tech and AI. The apparent disconnect between economic fundamentals and share price moves has been paralleled in markets such as Germany, where stocks have performed strongly in 2025 on fiscal expansion plans while the country struggles with an ongoing industrial crisis and severe pressure from Asian competition.
While there are major economic and political risks that could derail performance, there are indeed reasons for optimism about the year ahead for UK equities. It’s worth remembering here that around 75 per cent of revenue from companies in the FTSE 100 is generated in overseas markets, which theoretically lessens exposure to domestic travails.
Even after the market rally this year, UK valuations remain undemanding when compared to global peers. The FTSE All-Share trades on 13 times forward earnings, compared to 22 times for the S&P 500.
RBC Wealth Management head of investment strategy Frédérique Carrier noted that the UK market is rated “significantly below its long-term median price-to-earnings ratio relative to global developed markets, even accounting for sector differences”.
The Bank of England is poised to reduce interest rates further, which would be supportive for equities. The target bank rate was cut to 3.75 per cent this week. Inflation came in lower than expected at 3.2 per cent in November, fuelling forecasts of further cuts.
Analysts at Capital Economics forecast the FTSE 100 will rise from its current position of around 9,800 to 11,000 by the end of 2026. However, another double-digit uplift this year could still see the index lag the US and Germany.
As for where to look for UK opportunities for 2026, our latest Alpha screens provide a flurry of ideas. Our quality shares screen highlighted a potential value opportunity at British Airways owner International Consolidated Airlines (IAG). Elsewhere, our earnings upgrade momentum screen flagged stocks across the market cap spectrum which have enjoyed notable boosts to forecasts earnings, which include NatWest (NWG) and Lloyds (LLOY). Banks remain well-positioned for 2026 despite rate cuts, given rates are still relatively high against recent history and structural hedge programmes provide rising income.
Bearing in mind the expected path of rates, another sector to keep an eye on for next year is the housebuilders given the expected improvement in buyer demand. Sector valuations are cheap amid subdued sentiment and housing starts this year, but there are strong options available which are sending back good amounts of capital to shareholders. We recently stuck with our bullish position on Berkeley Group (BKG).
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