UK Spending Review: Fiscal Tightrope Walk Fuels Sectoral Winners and Losers

The UK government's 2025 Spending Review, allocating £2.7 trillion over the next four years, marks a pivotal moment in fiscal policy. With defense and healthcare absorbing disproportionate shares of the budget, the review has stark implications for investors: defense contractors are poised to benefit, while infrastructure firms face headwinds, and fiscal constraints could force tax hikes by 2026. Here's how investors should navigate this landscape.

The Spending Review's Stark Priorities

The review prioritizes healthcare and defense at the expense of capital projects like housing and transport. The NHS alone will command £193 billion in 2025–26, or 39% of total day-to-day spending, while defense spending is set to rise to 2.5% of GDP by 2027. By contrast, capital spending on infrastructure—already constrained—will grow just 1.3% annually, with defense absorbing most incremental funds.

This creates a stark divide:
- Winners: Defense contractors, pharmaceutical firms, and healthcare service providers.
- Losers: Infrastructure developers, construction companies, and sectors reliant on housing and transport investment.

Defense Contractors: A Secure Bet

The defense sector is the clearest beneficiary. With £24 billion allocated to MoD capital spending in 2025–26—the largest single component of capital outlays—firms like BAE Systems (BA.), Rolls-Royce (RR.L), and Leonardo (LDO) stand to gain from contracts for aircraft, submarines, and cybersecurity systems.

Why now? The UK's NATO pledge to reach 3% defense spending by 2030 will likely expand budgets further. Investors should also watch for spin-offs or partnerships, such as the proposed joint venture between BAE and Boeing (BA) for advanced fighter jets.

Infrastructure Firms: Bracing for a Slowdown

The squeeze on capital spending is a red flag for infrastructure stocks. Housing and transport projects, already starved of funds, face even tighter constraints. Firms like Costain Group (COST.L) and Stagecoach Group (SGC), reliant on public contracts, may see delayed projects or reduced scope.

Risk factors:
- Regional disparities: While £15.6 billion is earmarked for regional transport, London-centric projects remain favored, disadvantaging firms focused on less affluent areas.
- Climate projects: Energy security and net-zero initiatives (e.g., carbon capture) are fifth in capital priority, risking delays to green infrastructure.

Fiscal Tightrope: Tax Hikes Loom by 2026

The review's 1.2% real-terms growth for day-to-day spending and 1.3% for capital are historically low, underscoring fiscal fragility. The government projects a £9.9 billion surplus by 2029–30—the third-smallest on record—but this assumes no economic shocks.

Key risks:
1. Pay pressures: Public sector pay awards must average 2.0% cash (0% in real terms) to avoid breaching the envelope. Unions may push for higher wages, forcing tax hikes or cuts.
2. Debt dynamics: With public debt at 80% of GDP, rising borrowing costs could destabilize the surplus.

Investment Strategy: Play the Fiscal Hand

1. Focus on defense and healthcare:
2. Defense stocks: BAE, Rolls-Royce, and BAE's emerging tech arms (e.g., AI for intelligence systems).

3. Healthcare: AstraZeneca (AZN) and Imperial Brands (IMB), which benefit from NHS spending stability.

4. Avoid infrastructure-heavy stocks: Unless they have diversified revenue streams (e.g., National Grid (NGRD) with energy networks).

5. Hedge against fiscal tightening:

6. Inflation protection: iShares UK Inflation-Linked Government Bond ETF (ILGB).

7. Commodities: Gold (e.g., SPDR Gold Shares (GLD)) as a hedge against currency debasement if taxes rise sharply.

8. Monitor political risks: A 2024 election looms, and fiscal austerity could fuel voter backlash.

Conclusion

The UK's Spending Review is a fiscal tightrope walk, favoring sectors tied to government priorities while penalizing capital-heavy industries. Investors who align with defense and healthcare will capture upside, but they must also prepare for tax hikes by 2026 and inflationary pressures from constrained spending. Stay agile: fiscal policy is the new market driver.