UK Political Upheaval, Europe’s Valuation Puzzle, and the Rising Cost of Capital

After a strong first half of the year, markets have entered a more complicated phase. Political turbulence at home, a shift in Europe’s earnings outlook, and renewed concerns over fiscal discipline across developed economies are weighing on sentiment.

For UK investors, the key questions now are: how much does Westminster’s political noise matter for markets? Can European equities still offer value despite higher valuations? And what does a rising cost of capital mean for portfolios?

This week we explore those themes, beginning with the latest developments in the UK, before turning to Europe and the wider global picture.

UK - A Government in Reset Mode

The UK has been thrust into political turbulence once again following the resignation of Deputy Prime Minister Angela Rayner over tax allegations. Keir Starmer, just 14 months into his premiership, was forced into an emergency Cabinet reshuffle that has recast much of his front bench.

The shake-up places Shabana Mahmood at the Home Office and Pat McFadden at Work & Pensions, while David Lammy steps up as Deputy Prime Minister. The focus is now firmly on immigration and productivity - two issues that have consistently dogged the government. Yet the bigger challenge for Starmer is credibility: his pledge to deliver stability and competence looks increasingly fragile.

For investors, the key question is whether the government has enough political capital left to push through difficult fiscal choices in the autumn budget. Chancellor Rachel Reeves has signalled a need for gradual fiscal consolidation, but the room to manoeuvre is limited. The UK’s fiscal position is healthier than France’s, but still constrained. Bond investors are watching closely, with gilt yields sensitive to any sign of fiscal slippage.

Equity markets remain cautious. UK shares trade at a discount to global peers, but earnings momentum has weakened, and a potential windfall tax on banking profits could further dampen the outlook. The pound has been relatively resilient, benefiting from broad US dollar weakness, yet against the euro, sterling still looks vulnerable as growth differentials favour the Continent.

Where Is Your Pension Invested?

Europe - Strong Start, Slower Grind

European equities enjoyed a stellar run earlier in 2025, briefly outperforming US peers. But momentum has faded since March, with the STOXX 600 now flat for the year. Valuations have risen to the higher end of their 25-year range, with forward price/earnings ratios near 14.4. That places Europe at the 70th percentile of historic valuations. Not extreme, but no longer cheap.

The earnings backdrop has cooled. At the start of the year, analysts pencilled in 8% growth for 2025; consensus has since flipped to a 1% decline. Even the following year looks stretched, with consensus calling for 13% growth while more cautious forecasts sit nearer 4%. Much of the drag comes from a stronger euro, expected to rise towards 1.25 versus the dollar, reducing the value of overseas revenues for Europe’s large exporters.

Flows, however, are finally turning positive. After years of outflows, European equity funds are attracting inflows again, as investors diversify away from the US. Domestic investors in particular have been underweight their home market, having shifted heavily into US assets over the past decade. Even a modest reversal could be supportive for European markets.

Style performance has also diverged. Value stocks have led in Europe, while growth stocks, particularly tech, have dominated in the US. Concentration risk, so evident in America, is easing in Europe. Small-caps are performing better than in the US, aided by a pick-up in M&A and relatively attractive valuations.

Sector-wise, cyclicals such as banks, retailers and parts of technology look better placed, while autos, chemicals and commodity producers may lag. The broader picture, though, is of a region grappling with slower global trade, weaker demand from China, and an appreciation of the euro, all of which make selectivity essential.

Global - The Rising Cost of Capital

Beyond Europe, a common theme is emerging across markets: the cost of capital is rising.

In France, political paralysis has widened the spread between French government bonds and German Bunds to 80 basis points - its widest since 2024. Investors are less concerned about the sustainability of French debt and more about how efficiently the government spends. With limited appetite for reform, the risk premium attached to French bonds could rise further if uncertainty lingers.

The United States faces its own fiscal questions. A sweeping spending package has cast doubt on Washington’s commitment to discipline, while political pressure on the Federal Reserve has unsettled investors. Legal battles over the dismissal of a Fed governor have so far had little market impact, but they add to a sense of unease about central bank independence. Markets are pricing in a higher “term premium” for Treasuries, which is pushing yields higher at the long end and steepening the curve.

The UK sits somewhere in between. Gilts continue to offer relative value, particularly in the five-to-seven-year maturities, but fiscal tightening and slower domestic growth are constraining the outlook. For equities, this creates a less supportive environment, with earnings revisions softening and valuations already looking stretched.

Taken together, the story is one of bond markets gradually demanding more compensation for lending to governments. While short-term rates may fall as central banks ease policy, the longer end of the curve remains anchored by fiscal risk and inflation volatility. That higher cost of capital feeds through into equities by raising discount rates and injecting more volatility into valuations.

What It Means for You

For private investors, three takeaways stand out:

1. UK outlook remains cloudy. Political risk has resurfaced, and fiscal tightening will be a headwind for growth. UK equities still trade at a discount, but earnings revisions are heading lower.

2. Europe requires careful selection. Despite higher valuations, European equities remain cheaper than US stocks. But the stronger euro and slowing earnings outlook make stock and sector choice critical.

3. Rising global capital costs raise volatility. Bond markets are beginning to demand a higher term premium. Diversifying across maturities and regions remains crucial.

In short, the investment landscape is more nuanced than the strong start to the year suggested. There are opportunities, particularly in selective European cyclicals and quality UK assets, but the bar for returns is rising. Staying diversified, disciplined, and focused on long-term objectives remains the best defence in an uncertain world.