We maintain our bias towards quality UK large-cap stocks trading at a valuation discount to foreign competitors and prefer short-dated Gilts and investment-grade short-duration bonds.
June 18, 2025
By Frédérique Carrier and Rufaro Chiriseri, CFA
Following a cautious start, the Labour government has achieved two milestones: a rapprochement with Europe along with possible further steps in the future and a ‘trade agreement’ with the U.S. Though the 10 percent baseline U.S. tariff remains, there is some tariff relief for UK cars, steel and aluminium, resulting in an 11 percent average U.S. effective tariff rate on UK imports.
While these are important achievements, we believe the impact on the UK economy is likely to be muted. The re-engagement with the EU merely rolls back some of the obstacles introduced by Brexit, while the new average effective tariff on UK exports is not substantially different from what would have applied had the reciprocal tariffs remained in place.
The UK economy started the year on a reasonable footing, but in our view, large increases in taxes and energy costs will likely hinder economic growth. Surveys by the Confederation of British Industry and market research company GfK point to continued deterioration of business and consumer confidence. RBC Capital Markets expects GDP growth of only 1.0 percent in 2025 and 0.9 percent in 2026.
The government is attempting to tackle the sluggish economy with plans for homebuilding, defense and infrastructure spending. The Prime Minister announced an increase in defense spending to 2.5 percent of GDP by 2027 from the current 2.3 percent, with further increases likely, while the Chancellor set aside £113 billion for infrastructure projects over the current parliament. Taxes, as well as borrowing, will probably have to rise even further.
For large-cap equity investors, attractive valuation levels matter more than the domestic backdrop. The latter tends to have a more pronounced impact on small-cap equities.
The FTSE All-Share Index is trading well below its long-term median price-to-earnings ratio relative to global developed markets, even accounting for sector differences.
Though we currently suggest a modest Underweight in UK equities, quality UK large-cap stocks trading at a valuation discount to foreign competitors are an attractive opportunity for global investors, in our view. We also favour attractively valued Financials, given their high level of shareholder returns via both dividends and share buybacks.
The line chart shows the results of the Confederation of British Industry’s monthly Industrial Order Expectations survey from May 2007 through March 2025. Respondents are asked whether they expect output to increase or decrease over the next three months. More respondents expected decreases during the great financial crisis (2008-2010), during the COVID-19 pandemic (2020-2021), and since the beginning of 2024.
Source – Confederation of British Industry
The Bank of England (BoE) is on a “careful and gradual” path. While our base case is 75 basis points (bps) of easing through to year end, upside inflation risks remain especially in services, which could apply the brakes on cuts. Wage inflation is still meaningfully above the 3.0 percent to 3.5 percent level consistent with a 2.0 percent inflation level, but more importantly recent data shows signs of cooling. Furthermore, we think business hiring intentions will continue weakening, thus limiting wage growth and ultimately headline inflation in H2 2025.
The UK’s fiscal situation is also under pressure, with Q1 government borrowing data reaching the fourth highest on record. The Treasury’s spending needs are high, particularly in healthcare, education, and defense. While higher borrowing costs and lower productivity growth are exacerbating these fiscal pressures, we estimate a fiscal hole of £13–£23 billion depending on spending timelines. The Chancellor has three options to address this: (1) adjust the self-imposed fiscal rules, (2) cut departmental expenditures, (3) or raise taxes.
The Treasury’s decision to skew issuance further towards shorter-dated debt is likely due to declining demand from insurance and pension funds, and to higher longer-dated bond yields. While this tilt towards shorter maturities should be positive for Gilts, fiscal concerns and expectations of stubborn inflation have led to investors demanding higher yields on long-dated bonds. Gilts will remain sensitive to these factors, in our view. In the near term, we prefer short-dated Gilts. For long-term allocations, we think 10-year Gilt yields above year-to-date averages of 4.61 percent are compelling.
On one hand, corporate fundamentals improved due to rising profit margins in Q1. On the other hand, valuations look rich as credit spreads have tightened to levels below one-year averages. Consequently, spreads are inadequately compensating for credit risk especially in high-yield bonds. Near term, we prefer allocating in low-quality, investment-grade, short-duration bonds to cushion against potentially wider future spreads. We see value in Senior-Ranked Bank bonds, as well as Consumer Staples and Communications sectors.
The material herein is for informational purposes only and is not directed at, nor intended for distribution to or use by, any person or entity in any country where such distribution or use would be contrary to law or regulation or which would subject Royal Bank of Canada or its subsidiaries or constituent business units (including RBC Wealth Management) to any licensing or registration requirement within such country.
This is not intended to be either a specific offer by any Royal Bank of Canada entity to sell or provide, or a specific invitation to apply for, any particular financial account, product or service. Royal Bank of Canada does not offer accounts, products or services in jurisdictions where it is not permitted to do so, and therefore the RBC Wealth Management business is not available in all countries or markets.
The information contained herein is general in nature and is not intended, and should not be construed, as professional advice or opinion provided to the user, nor as a recommendation of any particular approach. Nothing in this material constitutes legal, accounting or tax advice and you are advised to seek independent legal, tax and accounting advice prior to acting upon anything contained in this material. Interest rates, market conditions, tax and legal rules and other important factors which will be pertinent to your circumstances are subject to change. This material does not purport to be a complete statement of the approaches or steps that may be appropriate for the user, does not take into account the user’s specific investment objectives or risk tolerance and is not intended to be an invitation to effect a securities transaction or to otherwise participate in any investment service.
To the full extent permitted by law neither RBC Wealth Management nor any of its affiliates, nor any other person, accepts any liability whatsoever for any direct or consequential loss arising from any use of this document or the information contained herein. No matter contained in this material may be reproduced or copied by any means without the prior consent of RBC Wealth Management. RBC Wealth Management is the global brand name to describe the wealth management business of the Royal Bank of Canada and its affiliates and branches, including, RBC Investment Services (Asia) Limited, Royal Bank of Canada, Hong Kong Branch, and the Royal Bank of Canada, Singapore Branch. Additional information available upon request.
Royal Bank of Canada is duly established under the Bank Act (Canada), which provides limited liability for shareholders.
® Registered trademark of Royal Bank of Canada. Used under license. RBC Wealth Management is a registered trademark of Royal Bank of Canada. Used under license. Copyright © Royal Bank of Canada 2025. All rights reserved.
We want to talk about your financial future.