The UK's FTSE 100 and FTSE 250 indices have risen 8% and 9% respectively so far this year, 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 energy, consumer staples and healthcare sectors, which together account for about 40% of the FTSE 100's weighting.
At the same time, lower valuations and more stable gilt yields have boosted mid-cap stocks.
However, just as global investors are turning bullish on the UK market again, Wednesday's Autumn Budget will serve as a major test for the country's stock market.
The bond market's "punishers" will assess potential tax increases or consumer support measures, weighing these against the UK government's limited fiscal room.
Autumn Budget May Be Market-Friendly, but Risk-Reward Varies Across Sectors
The UK government is set to unveil its Autumn Budget on October 28.
After the previous Chancellor raised taxes by more than 60 billion pounds (about $80 billion) across two budgets, current Chancellor John Healey has no intention of introducing another large, headline-grabbing fiscal package.
A few phrases repeatedly used recently by Healey and his Treasury officials — "do no harm," "stay the 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, public-pleasing spending plan by raising bank taxes, in order to help voters and businesses squeezed by energy costs driven higher 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 industries, covering 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 major policy shifts, and may mainly redistribute spending to support households and businesses.
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 puts forward a credible fiscal plan that both stabilizes public finances and avoids a clear hit to consumption, gilt yields could fall and the equity risk premium could narrow.
But if the government fails to convince investors that public finances are sustainable, or if budget measures worsen inflation, financing and consumption pressures, long-term gilt yields could continue to rise and limit the continuation of this UK stock market rally.
Citi strategists led by Beata Manthey said: "We see a tactical case for the FTSE 100 to outperform, because UK equities can effectively hedge geopolitical risk. However, over the medium term, we remain underweight UK in global portfolios."
Citi economists expect the UK government to deliver a market-friendly budget that prioritizes fiscal credibility.
But the bank's industry 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 push structural reforms whose potential impact the market may not 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 gilt yields pressure housing affordability.
For banks, the budget could be a key moment to remove uncertainty.
Analysts said the market has largely priced in the possibility of a higher bank surcharge, and the gilt market's reaction after the budget is announced may be a more important factor affecting bank sector valuations.
Measured by book value, a clear gap has emerged between UK banks' valuations and their return on equity, and this gap is more pronounced than elsewhere in Europe.
This suggests that although UK banks have higher returns on equity and sovereign bond spreads on the continent are widening, 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 analysts pointed out that each 1 percentage point increase in the UK bank surcharge is expected to drag Barclays (BCS.US) 2028 net profit expectations by about 0.5%; for Lloyds (LYG.US) and NatWest Group Plc, the drag on 2028 net profit expectations would be slightly more than 1%.
Goldman 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 is whether the UK-specific risk premium can fall and whether market confidence in the UK economy can strengthen."
In addition, after the budget is released, the next major risk event will be the Bank of England's rate decision on November 5.
The market has almost fully priced in a hike, which would be the first of four hikes expected by the market through 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 no surprise that UK consumer confidence fell this month by the largest margin 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 positioning toward more defensive assets.
According to Morningstar data, UK large-cap exchange-traded funds (ETFs) have attracted an estimated $3.4 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 (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 usually follow market performance, but this also reflects investors' desire to diversify away from US large-cap tech stocks and further broaden their equity allocation."
UK large-cap ETF inflows hit their highest since 2020.
Meanwhile, according to a fund manager survey released by Bank of America earlier this month, investors are now 26% net underweight UK equities, down from 35% net underweight 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.
Still, 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 $100 per barrel, and the energy sector is a major driver of FTSE 100 earnings growth.
Because analysts expect oil prices to fall next year, the market forecasts FTSE 100 earnings per share growth to slow to just 5% in 2027, compared with an expected 30% in 2026.
Nevertheless, UK equity valuations remain undemanding, which may provide some cushion for both large-cap and mid-cap stocks.
The FTSE 350 trades at a 30% discount to global equities, remaining one of the main attractions of the UK stock market.
The UK stock market is not only a low-cost way to diversify exposure, but also one of Europe's most active markets for M&A activity, especially in mid-caps.
A team of HSBC strategists 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 main impact of the budget is a stronger pound."
The team maintained a neutral stance on the UK market overall 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."
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