UK equities − a haven for income and value

The IMF forecasts little narrowing in growth differentials for 2025, though the recovery in Europe are modest, and rely on policy easing boosting demand. The UK avoided a contraction in Q4 2024, growing by 0.1% y/y, resulting in an annual growth of 0.9% for 2024, with growth projected to nearly double in 2025 (Chart 2), while the Bank of England recently halved its growth forecasts to 0.8% to reflect growing uncertainty, especially over Trump tariffs, which remain a risk to the global economy.

Inflation has loomed large over the post-pandemic recovery. The consumer price index has climbed sharply, peaking at over 10% in 2022, driven by energy price shocks and supply disruptions. Although headline inflation has since eased, it is expected to rise in 2025. UK services inflation has remained stubbornly high (Chart 3), reflecting strong wage growth due to its high share of labour costs in service sector costs. Only a surge in productivity growth would allow these higher labour costs to be absorbed. As a result, achieving 2% inflation remains a major challenge in the UK, with policymakers having to walk a tightrope between economic growth and price stability.

Sterling’s fortunes have mirrored the UK’s broader economic challenges. Chart 4 shows GBP/USD and the UK-US interest rate differential to illustrate the delicate interplay between currency strength and central bank policy. A widening rate differential has lent occasional support to the pound but not without setbacks. Post-Brexit uncertainty and the pandemic have weighed heavily on the currency, but overall sterling has stayed within a trading range since 2016. Currency dynamics have important implications for UK equities. A weaker pound boosts the earnings of exporters and globally oriented companies, a key feature of the FTSE 100. Conversely, a stronger pound erodes their competitive edge but may benefit domestic sectors.

The FTSE 100 and FTSE 250 indices paint contrasting pictures of the UK equity market. Over the last year, the FTSE 100, home to large-cap, globally diversified companies, delivered an impressive 15.3% return in US dollar terms. Its heavy exposure to defensive sectors − energy, financials, and consumer staples − has shielded the UK market from the weak domestic economy and enabled it to benefit from a global rotation into value stocks.

The FTSE 250, by contrast, has gained just under 10% in 2024 and struggled more recently. Representing mid-cap firms with greater exposure to the UK’s domestic economy, the index declined slightly over the last three months. Persistent inflation, slower domestic growth, and rising borrowing costs have weighed heavily on this segment, underscoring the uneven recovery across market tiers.

The geographic revenue exposure of UK-listed firms highlights their dependence on global markets. The FTSE 100 derives nearly 30% of its revenue from the United States, far outstripping contributions from other regions such as Japan and China. This underscores the critical role of the US economy in driving earnings for UK-listed companies.

However, the prospect of US tariffs adds an element of risk to this dynamic. Recent policy discussions in the US suggest that tariffs could be reintroduced or expanded, targeting industries such as technology, healthcare, and even financial services. For UK companies, this presents a double-edged sword: while some sectors, like consumer staples, may remain insulated, industries with high exposure to US markets, such as financials and energy, could face margin pressure if costs rise or demand weakens.

In addition, tariffs could exacerbate global supply chain challenges, especially for firms reliant on raw materials or intermediate goods traded between the UK and the US. The FTSE 100’s reliance on US revenue means any such measures would disproportionately affect its earnings relative to indices with more diversified exposure, such as the FTSE Developed ex-US.

Dividend yields remain comparatively attractive in the UK, as shown in Chart 7. The FTSE 100 boasts a substantial portion of companies offering yields above 4%, cementing its reputation as a haven for income-seeking investors. This reflects the sectoral skew of the index, with a strong presence in cash-generative industries such as utilities, energy, and consumer staples.

In terms of style, the FTSE 100 leans heavily towards value stocks. The chart on style comparison shows that a large portion of its constituents are classified as “large-value” in stark contrast to global indices, which have a stronger orientation towards growth sectors like technology. This tilt has benefitted the FTSE 100 during periods of inflation and rising interest rates, but it leaves the index at a disadvantage when growth stocks dominate global markets.

Finally, its valuation remains among the lowest within peers, presenting unparalleled opportunities as the UK economy recovers and regulatory changes boost UK equity ownership. 

While the FTSE 100’s value-driven, defensive profile has its merits, it also highlights a structural limitation - the UK market’s relative lack of exposure to high growth sectors. The industry weight comparison reveals a glaring gap in technology and consumer discretionary stocks, which have powered global equity returns in recent years. Meanwhile, heavyweights like energy and financials dominate the FTSE 100, offering stability but little in the way of innovation or growth.

The FTSE 250, often regarded as a barometer for the UK’s economic health, suffers from its own limitations. Its concentration in domestically focused sectors makes it vulnerable to the persistent inflation and tepid growth currently gripping the economy.

The UK’s equity markets face a challenging but not insurmountable future. Much will depend on the trajectory of inflation and how the Bank of England balances growth and price stability. Global factors, from US monetary tightening to China’s growth trajectory, will remain influential given the UK market’s international orientation.

At the same time, the structural composition of the FTSE 100 and FTSE 250 demands attention. Policymakers and corporate leaders must work to foster innovation and investment in high-growth sectors if the UK is to compete with more dynamic markets abroad.

For investors, the UK market offers a blend of defensive characteristics and income appeal, but selectivity will be crucial. The FTSE 100 remains well-suited to those seeking stability and yield, while the FTSE 250 may appeal to contrarians betting on a domestic recovery. In an era of heightened uncertainty, balancing exposure to UK equities with global diversification remains the most prudent approach.