Weakening labour markets could spur further Bank of England rate cuts and Gilt strength, even as the UK’s undervalued equity market offers opportunities.
December 2, 2025
By Frédérique Carrier, Rufaro Chiriseri, CFA and Thomas McGarrity, CFA
The tax increases imposed on businesses and households in 2025 are expected to further slow economic growth to just 1.2 percent in 2026, according to the Bloomberg consensus forecast. Slowing growth will likely allow inflation to ease further, which could give the Bank of England (BoE) room to cut interest rates beyond the 3.25 percent level that is currently priced in by markets for year-end 2026.
In our view, the risk is that an increasingly unpopular Labour government abandons fiscal discipline. Elected with a landslide majority in July 2024, the government’s approval rating has since plunged to 17 percent, according to recent polls. It is hard for us to see it recovering given the belt-tightening imposed on voters. If the government loosens its fiscal stance to spur growth – and its approval rating – financial markets would likely turn jittery, in our view, especially as the UK relies heavily on foreign investors to finance its debt.
The chart, as of October 3, 2025, shows the voting intentions for the five main political parties in the UK since the July 2024 general election. Voting intentions for Labour have dropped to less than 25% from 40%. Labour’s support recovered slightly in the three months following the election but then steadily declined, so that it now stands at less than 21%. By contrast, voting intentions for the right-wing Reform party have increased steadily since the general election, to 31% from 16%. The Conservatives, while enjoying an increase in voting intentions from July to October 2024, have also suffered a deep decline, with voting intentions for the party now standing below 17%. The Greens and the Liberal Democrats have seen a slow improvement in their voting intentions during this period, now standing at 10% and 13%, respectively.
Source – Election data vault
For a country that averaged an annual growth rate of two percent in the decade before the pandemic, the UK’s sluggish economic performance is disappointing. However, circumstances have changed, and a fairer comparison, in our view, may be with other G7 economies – all of which face their own challenges.
Perhaps because of that external environment and thanks to attractive valuations, the FTSE All-Share Index has gained 15 percent year to date in local currency terms, or 20 percent in U.S. dollar terms, largely outperforming the S&P 500’s 11 percent year-to-date return. The outperformance is striking, especially given the UK’s limited exposure to technology stocks, the main driver of U.S. and Asian stock markets in 2025.
Absent major changes to the UK’s fiscal policies, we think UK equities could continue to perform well. Valuations still look attractive to us despite the rally, with the FTSE All-Share Index trading at 12.5x 2026 consensus earnings estimates, significantly below its long-term median price-to-earnings ratio relative to global developed markets, even accounting for sector differences.
We continue to favour attractively valued companies in the Financials sector, given their propensity for a high level of shareholder returns via dividends and share buybacks. Should the BoE loosen monetary policy more than markets currently expect, interest-rate-sensitive industries, such as housing, could outperform.
Our base case calls for continued softening in the labour market, including wage pressures, leading to increased confidence that the Bank of England will cut interest rates by 50 basis points from December through to Q1 2026. Business surveys expect pay growth to average around 3.7 percent during the year, and we forecast headline inflation to reach 3.5 percent year over year by the second quarter. A wide range of fiscal tightening measures are being backloaded in the 2029-30 period of the budget, while spending is frontloaded. Therefore, the growth impact in 2026 will be minimal and our economists project a gross domestic product growth rate of 1.1 percent for the year. The risk to our base case view is the potential for household inflation expectations becoming anchored around the six-month average of four percent; this could put pressure on wage demands.
Tax hikes amounting to £26.1 billion, along with the increased “headroom” – the margin of safety between tax and spending plans – to £21.7 billion from £9.9 billion, has been positively received by markets. Against the backdrop of lowered fiscal risks and looser monetary policy, Gilts should remain stable and potentially outperform, in our view. Furthermore, Treasury’s bond issuance is likely past its peak and will continue being skewed away from long-dated Gilts where natural pension demand has fallen. That being said, Gilts could remain volatile, given the delayed fiscal consolidation, and the increased reliance on yield-sensitive investors needed to mop up supply.
UK corporate bonds have largely shrugged off fiscal concerns, with credit spreads – the compensation for credit risk – remaining at tight levels. We forecast a modest widening of spreads into 2026; therefore, we prefer an Underweight position in corporate bonds. However, current yield compensation for interest rate risk is still at compelling levels. Furthermore, we think lower Gilt yields and lower borrowing costs will support the credit sector.
The chart shows the Bloomberg Sterling Corporate Index spreads over a 5-year horizon from November 11, 2020, through to November 10, 2025. During this period, the index began at 1.34% and trended upward to a high of 2.58% on October 12, 2022. After that time, the general trend was a decline to a low of 0.90% on February 7, 2025. The latest reading on November 11, 2025, shows 0.87%. The chart also shows the 1- and 5-year averages of the index of 1.00% and 1.35%, respectively, during the same period.
Source – Bloomberg, RBC Wealth Management; data as of 11/10/25
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.