Since the last Budget, an unusual divergence has emerged in UK equity markets. Historically, materially lower short‑term interest rates have tended to favour the FTSE 250 over the FTSE 100. A move lower of around 140 basis points in two‑year gilts would typically have triggered meaningful outperformance from the more domestically focused FTSE 250. This time, however, the reverse has occurred, with the FTSE 100 taking the lead.
This is particularly striking given that trade‑weighted Sterling has risen nearly 10% from its 2022 lows. Ordinarily, such a move would act as a headwind for the FTSE 100, given that around 80% of its revenues are generated overseas. Add to this the backdrop of US trade policy, which—other things being equal—should favour domestic earners, and the current market dynamics appear even more counterintuitive.
Why is the FTSE 100 outperforming the FTSE 250?
- Elevated short‑term rates: Even after recent declines, the absolute level of short‑term rates remains high in the context of the post‑Global Financial Crisis environment. For UK domestic and small/mid‑cap companies, elevated borrowing costs, mortgage resets, and tight lending standards have limited the usual benefit of falling two‑year yields.
- The reason behind falling rates matters: A decline driven by cooling inflation (“good disinflation”) can support equities broadly. By contrast, a fall prompted by growth concerns tends to favour defensives and US dollar earners over domestic cyclicals. The legacy of the Chancellor’s first Budget has been weaker growth alongside higher domestic inflation—a challenging combination for companies geared to the UK economy.
- Sector and earnings specifics: Large UK banks, energy, healthcare, and staples have benefited from cash returns, buybacks, and balance sheet strength. These factors have overridden the normal pattern of lower rates correlating to FTSE 250 outperformance. Meanwhile, property‑linked names and domestic cyclicals—more heavily represented in the FTSE 250—continue to wrestle with soft demand and refinancing headwinds.
- Structural flows and valuation pressures: UK mid and small caps have faced persistent outflows. Morningstar reports that UK small caps have seen uninterrupted outflows for over three years, weighing on valuations and investor sentiment.
Looking Ahead
The FTSE 250 has historically been the growth‑oriented index, yet its trailing 12‑month price‑to‑earnings ratio now sits below that of the FTSE 100. Against a backdrop of “national capitalism” that should increasingly favour domestic earners, there is scope for a reversal.
If the forthcoming Budget avoids the pitfalls of micro‑taxation seen in 2024 (notwithstanding the government’s announcement that income tax will not be raised), it is likely to pave the way for a meaningful reduction in base rates next year. Such a move would boost consumption, support housing, and provide a catalyst for broad‑based outperformance of the FTSE 250 relative to the FTSE 100.
At JM Finn, we of course will be watching the upcoming Budget closely and will carefully consider the possible impact on client portfolios.
The value of securities and the income from them can fall as well as rise. Past performance should not be seen as an indicator of future returns. All views expressed are those of the author and should not be considered a recommendation or solicitation to buy or sell any products or securities.
