UK Equities and the Fiscal Dilemma: Can Strong Stock Performance Offset Rising Debt Risks?

The UK stock market has reached unprecedented heights in 2025, with the FTSE 100 index closing at 8,998.06 on July 14, 2025, and hitting an intra-day high of 9,016.98 two days later. These milestones mark a remarkable recovery from the pandemic-era lows of 2020 and reflect strong performance across global-facing sectors. Yet, this bullish equity market story exists in stark contrast to a deteriorating fiscal landscape, where the UK's public sector net debt now stands at 96.3% of GDP - a level not seen since the early 1960s. This divergence raises critical questions for investors: Can the current equity market euphoria sustain itself in the face of growing fiscal vulnerabilities? And what are the risks of policy-driven market corrections as the government grapples with its deteriorating public finances?

The FTSE 100's recent surge has been driven by several factors. First, the index's composition has evolved to include more multinational corporations that derive significant revenue from overseas markets. Companies like AstraZeneca, Shell, and Unilever now account for 27% of the index's total capitalization, benefiting from global demand patterns and structural shifts in energy and healthcare markets. Second, the index has capitalized on the strength of commodity prices, particularly in copper and gold, which have surged due to the AI boom, clean energy investment, and geopolitical uncertainty. Mining stocks like Rio Tinto and Anglo American have contributed meaningfully to the index's performance. Third, the FTSE 100 has become an attractive income play, with its dividend yield outpacing many developed market indices.

However, these positive fundamentals for equities exist alongside troubling trends in public finances. The Office for Budget Responsibility's (OBR) latest Economic and Fiscal Outlook (EFO) for 2025-30 reveals a deteriorating fiscal outlook. Public sector net borrowing is forecast to remain elevated, with debt servicing costs rising due to higher interest rates and inflation. The OBR notes that while fiscal policies announced in the March 2025 Spring Statement are expected to improve the current balance by £14.0 billion by 2029-30, the headroom against the government's fiscal mandate is only £9.9 billion - a very narrow margin given historical forecast revisions.

The most alarming aspect of the current fiscal situation is the mismatch between equity market optimism and the underlying economic fundamentals. The FTSE 100 has outperformed other major global indices in 2025, rising 10% in US dollar terms and 18% in sterling. This outperformance has occurred despite the UK's deteriorating public finances, with borrowing reaching £20.7 billion in June 2025 - the second-highest June borrowing since records began in 1993. The rising costs of public services and interest payments on index-linked gilts have pushed up overall spending more than increases in tax receipts, leading to higher borrowing.

This divergence between equity markets and public finances raises several concerns. First, the UK's fiscal trajectory suggests that further tax hikes are likely, particularly in the October 2025 Budget. Economists like Rob Wood from Pantheon Macroeconomics have suggested that tax increases on alcohol and tobacco could be announced, along with potential reforms to pension taxation. These measures could dampen consumer and business sentiment, ultimately affecting corporate earnings.

Second, the OBR's analysis highlights significant uncertainty in the fiscal outlook. The headroom of £9.9 billion against the fiscal mandate is only one-third of the average £31.3 billion that Chancellors have historically set aside against their fiscal rules. Given the average absolute final-year revision to pre-measures borrowing over the past ten forecasts has been £19.4 billion, the current narrow margin leaves little room for error. If productivity growth remains weak - currently averaging just 1.0% per year in the OBR's central forecast - the current budget could be in deficit by 1.4% of GDP in 2029-30.

For investors, this divergence between equity markets and public finances creates a complex investment environment. On one hand, the FTSE 100 offers attractive valuations, particularly in the mid-cap segment (FTSE 250), which has outperformed large-caps with stronger earnings growth. UBS strategist Sutanya Chedda notes that while large-caps have closed the valuation gap somewhat, the UK's valuation gap "remains wide, and there is still a lot of value in UK SMIDs." The FTSE 250 is expected to deliver 15% EPS growth in 2025, compared to just 2% for the FTSE 100.

On the other hand, the deteriorating fiscal outlook introduces significant risks. If the government is forced to implement more aggressive fiscal tightening measures than currently anticipated, this could negatively impact corporate earnings and investor sentiment. The OBR's analysis suggests that the probability of meeting the fiscal mandate is only 54%, reflecting the high degree of uncertainty in the forecast.

Investors should also be mindful of the potential for policy-driven market corrections. The government's announced policies, including welfare and planning reforms, were not fully incorporated into the current forecast due to insufficient information and late submission of policy details. As a result, the full economic and fiscal effects of these reforms will be evaluated in the next forecast, introducing additional uncertainty into the market outlook.

For those considering UK equities as part of their investment portfolio, a balanced approach is warranted. While the FTSE 100 offers exposure to global growth and income generation, investors should diversify into the FTSE 250 to capture the stronger earnings potential of mid-cap companies. Particular attention should be paid to sectors with more defensive characteristics, such as financials and utilities, which are less sensitive to macroeconomic headwinds.

Investors should also maintain a close watch on fiscal developments. The October 2025 Budget will be a critical moment, as it may bring further tax hikes or fiscal rule adjustments that could impact market sentiment. In the meantime, the Sizewell C nuclear power plant project and other capital investments offer some structural support for the economy, potentially mitigating some of the negative impacts of fiscal tightening.

In conclusion, while the FTSE 100's record highs reflect strong performance in global-facing sectors and attractive valuations, the deteriorating public finances present significant risks. The narrow fiscal headroom, uncertainty in the economic outlook, and potential for policy-driven market corrections suggest that investors should approach UK equities with both optimism and caution. A diversified approach that balances exposure to large-caps and mid-caps, while maintaining awareness of fiscal developments, offers the best path forward in this complex investment environment.