UK Services Sector Stumbles: Shift to Defensive Plays Amid Inflationary Crosscurrents

The UK services sector, the lifeblood of the British economy, is entering a precarious phase. New CBI data reveals a deepening crisis: business confidence has hit a 2-1/2-year low, consumer-facing industries are slashing investments, and cost pressures are surging ahead of selling price increases. For investors, this is a stark warning to pivot toward sectors that can weather inflation and weak demand—specifically utilities and healthcare—while avoiding overexposure to consumer services.

The Services Sector's Downward Spiral

The CBI's latest findings paint a bleak picture. In consumer services—a category encompassing retail, hospitality, and travel—business volumes have plummeted to -53%, with expectations of a further decline to -55% in the coming quarter. Cost growth, however, is exploding: total costs per employee are projected to hit +75% next quarter, far outpacing selling price inflation of just +48%. This divergence is squeezing profitability, which has already fallen to -35% and is expected to plummet to -55%.

Employment is also contracting, with consumer services firms anticipating a 53% decline in headcount. The sector's struggles are being exacerbated by rising labor costs (cited by 39% of larger firms as a key challenge) and weak household spending. For investors, this is a clear signal: consumer-facing businesses are now high-risk plays, vulnerable to both inflation and demand shocks.

Defensive Sectors: The Anchor in Turbulent Waters

Amid this turmoil, defensive sectors offer a lifeline. Utilities and healthcare are two industries uniquely positioned to thrive in an inflationary environment.

1. Utilities: Regulated Stability

Utilities companies, such as National Grid (NG.L) and SSE (SSE.L), operate in a tightly regulated environment that allows them to pass on cost increases to consumers. This “inflation hedge” ensures steady cash flows even as prices rise.

The CBI data highlights that utilities are largely insulated from the services sector's demand slump. With energy costs expected to remain elevated due to global supply dynamics, utilities can maintain pricing power. Additionally, their dividend yields—typically above 5%—provide a cushion against market volatility.

2. Healthcare: Necessity Over Luxury

Healthcare services, including providers like Imperial Health Science (IHS.L) and pharmaceutical giants such as AstraZeneca (AZN.L), benefit from inelastic demand. Whether the economy is booming or contracting, patients still require treatment.

The CBI report notes that worker shortages in healthcare are intensifying (affecting 18% of larger firms), but this also creates opportunities for firms with strong staffing strategies or automation capabilities. Additionally, healthcare companies often have long-term contracts with governments or insurers, shielding them from short-term economic swings.

The Case for Dividends and Defensive Allocations

Investors should prioritize stable dividend payers in these sectors. Utilities and healthcare companies typically have robust balance sheets and predictable cash flows, enabling them to sustain or grow dividends even during downturns. For example, National Grid's dividend yield stands at 5.2%, while AstraZeneca's dividend growth has outpaced inflation over the past decade.

Avoid Consumer-Facing Traps

The CBI data underscores the risks of clinging to consumer services stocks. Retailers like Next (NXT.L) and hospitality firms like Whitbread (WTB.L) face a toxic mix of rising input costs (labor, energy) and weakening demand. Their profit margins are under siege, and their ability to raise prices without losing customers is limited.

The Bottom Line: Act Now, Before It's Too Late

The writing is on the wall: the UK services sector is in a cyclical downturn, and inflationary pressures are here to stay. Investors who ignore this reality risk significant losses. Instead, pivot to utilities and healthcare—sectors with built-in inflation hedges and stable demand.

The time to reposition portfolios is now. Target dividend-paying defensive stocks and avoid consumer-facing sectors until the cost-demand imbalance corrects. As Alpesh Paleja of the CBI warns, “the sector's struggles require urgent policy action”—but for investors, the most urgent action is to protect capital.

This analysis is based on CBI data as of Q2 2025 and is not financial advice. Consult a professional before making investment decisions.