Aurelia Butler

The UK economy contracted less than expected in December as growth in the health sector offset the blow that the Omicron coronavirus variant dealt to many services industries. Gross domestic product rose 7.5 per cent over 2021 compared with the previous year — the strongest pace of growth since the second world war — as the economy rebounded from the pandemic hit in 2020, despite continued weaknesses in its trade performance. Output fell 0.2 per cent between November and December, data from the Office for National Statistics showed on Friday. That was a smaller decline than the 0.6 per cent drop forecast by economists polled by Reuters, but it was the largest contraction since January 2021.“GDP fell back slightly in December as the Omicron wave hit, with retail and hospitality seeing the biggest impacts,” said Darren Morgan, ONS director of economic statistics. “However, these were partially offset by increases in the Test and Trace service and vaccination programmes.”Output expanded 1 per cent in the final quarter of the year compared with the previous one, thanks to strong growth in November.In the three months to December, GDP was still 0.4 per cent below its level in the final quarter of 2019, before the pandemic hit. In contrast, output in the US, China and the eurozone recovered the ground lost during the crisis.“The UK economy’s performance continues to underwhelm relative to its peers in the G7,” said Samuel Tombs, economist at Pantheon Macroeconomics.However, assessing the extent to which the UK economy has recovered from the hit of the pandemic is complicated by differences in which the ONS calculates monthly and quarterly data. On the monthly figure, GDP in December was in line with its pre-pandemic level in February 2020.The ONS also published its trade data and showed that imports from non-EU countries had surpassed those from EU economies in 2021 for the first time since records began in 1997. Cornelius Clarke, economist at the financial services Ebury, said that “evidently the end of the Brexit transition period has impacted trading relationships that many UK businesses have with their EU counterparts.”Annual imports and exports in 2021 increased by 8 per cent and 5 per cent respectively compared with 2020, but both remained lower than 2018 levels.Tombs said that while the coronavirus “can’t be blamed” for the UK’s continued underperformance, “exports continue to stand out as an area of significant weakness.” Growth in December was dragged down by services, where output fell 0.5 per cent compared with the previous month as consumers spent less in cinemas, bars, and restaurants because of the spread of Omicron.Retail sales and output in the hospitality sector fell 3.7 per and 9.2 per cent respectively. Output in arts and recreation fell 4.4 per cent.The fall in those sectors was offset by a 2.4 per cent expansion in the health sector, which the ONS said was largely driven by the NHS test and trace and vaccination programme.Manufacturing output rose 0.2 per cent, boosted by growth in the pharmaceutical and car sectors. Construction also increased by a solid 2 per cent supported by strong expansion in infrastructure and new housing.In its latest assessment of the economy, the Bank of England said that it expected the impact of Omicron to “be limited and of short duration,” with GDP recovering in February and March. However, it also warned that growth in 2022 will be dragged down by the largest contraction in household real income in 30 years because of rising inflation, higher taxes, and surging energy costs. More

Good morning. Once a month we write about the CPI report. Rules are rules. I think the market is overacting a bit. Think different? Email me: [email protected] changes, big scareLet’s start at the end of the movie, and work backwards towards the beginning. The ultimate expression of Thursday’s gnarly market response to the CPI report can be seen in the fed funds futures market. Before the report, the futures implied a one in four chance that the central bank would do a double-weight rate increase — half a percentage point — in March. After the report, the probability rose to more than 90 per cent. Oh, the drama:Broadening the frame, the whole interest rate curve moved up. The two-year bond followed the fed fund futures, pricing in an additional rate increase almost immediately. That’s a whopping big move. While the long end of the curve moved up non-trivially, as well, the flattening of the curve was significant.A flatter curve may not make tons of sense, in the abstract, as an indicator that the Fed will tighten policy so abruptly that it causes a recession. But the market, like the heart, has reasons that reason cannot know. Inverted curves scare everyone to death. The 10-year minus 2-year curve has now fallen 1.2 percentage point since March. Another half a point and it’s inverted. Expect to see a lot of pictures like this in the next few weeks:Fear was perceptible in the stock market, too. The Nasdaq lost more than 2 per cent, as the increase in long-bond yields was driven, once again, by an increase in real yields, not inflation expectations (once again: Is there good reason tech stocks need to move conversely with real yields? Not really. Does that seem to be the pattern these days? Sure does). The S&P didn’t do much better. Some part of yesterday’s febrile climate is down to James Bullard, who runs the St Louis branch of the Fed. Mid-day yesterday, Bloomberg reported that Bullard supports raising the policy rate to 1 per cent by mid-year. He was also quite flirty about the possibility of a 50 basis point move in March. But the main culprit was the CPI report itself, of course. Headlines latched on to the year-over-year increase in the full index. At 7.5 per cent, it was at a multi-decade high and perhaps 30 basis points higher than expected. At Unhedged, we’ve lately become converts to looking at the month-to-month core numbers. Here is a picture:Start with core inflation (that is, excluding food and energy) in dark blue. After two months of deceleration, it was basically flat, which is not great, but north of horrific. Second: durable goods, where inflationary pressure has been greatest, in light blue. It fell a little in January — an encouraging sign. Third: core non-durable goods, in mid-blue. This is clothes, tobacco, cleaning products, and the like. Slowing for the fourth straight month. Good stuff.Not an awful picture, so far. So why the violent reaction? Rent picked up a bit, but that was widely expected. Was the market looking for more deceleration this month? Certainly, there is a strong consensus that inflation will decline significantly this year, but not until the second half. The wild reaction is a bit of a puzzle. Here is a possible explanation. Look at the little red bars, above. Services inflation accelerated. Just by a touch; but as I’ve noted a month ago, any acceleration looks bad, if you are inclined to think inflation is going to get dug in. To reiterate. The overarching narrative of the current inflationary incident is that the pandemic makes it hard to consume services, which so often require proximity. The stimulus programmes ensure American households and companies maintain, and in some cases increase, their spending power. Demand shifts massively to goods. Supply chains can’t keep up, and prices rise. If services prices rise, therefore, that is a sign of inflation “leakage” beyond the places where the problem began. And the leakage is bringing inflation to places where prices tend to stick, such as rent and personal services, from haircuts to car repair.Consider the Atlanta Fed’s index of those historically “sticky” prices (one month changes, annualised):

The January sticky-price increase was the biggest monthly move (4.3 to 7.5 per cent) since the start of the pandemic. And this comes on top of strong moves up in the Fed’s preferred measure of wages, the employment cost index, which is now running at a four per cent annual rate in its last quarterly reading (wage increases are thought to be a main channel though which price increases spread). The CPI report, to sum up, had just enough in it to whip up fears of sticky inflation that were already present in markets. That said, Thursday’s market response looks like an overshoot. The plain fact is that January’s report was only marginally worse than December’s. Markets are jumpy. Be careful out there.One good readYou cannot consider yourself a proper inflation geek until you have read a 26-page paper about how nail prices have changed over the last 325 years. I mean, look at this:

Nails! More

I think the science is settled (I’m pretending economics is a science to make a joke, please humour me).Last year saw something of a row between central bankers, who absolutely insisted that any inflation you could see around was entirely transitory (and would be gone in a matter of months) and the rest of us who weren’t so sure.Today, consumer prices in the US are rising at 7.5 per cent, the fastest since 1982. In the UK the figure is 5.4 per cent.That’s frighteningly high. Given how hard it is to imagine central bankers being able to do much about global supply problems, it’s also clearly not very short term. It’s beginning to have an all-too-obvious effect, not just on living costs but on investment portfolios as well.That’s unlikely to end soon. The market has long preferred fun tech stories and has discouraged oil and gas companies and miners from investing in exploration and production. So they haven’t.Now we find ourselves in something of a supply crunch: we need more energy, more copper, more lithium and more steel — but none of these things are readily available. So energy prices are high and rising, as are metals prices. Food prices will soon follow (they are linked to energy prices via fertiliser prices but with a delay due to long-term supermarket contracts with providers). And this is exactly the kind of environment that leads to bear markets. As Charles Gave of independent research house Gavekal likes to point out, structural bear markets usually begin “when oil is undervalued versus stocks and inflation is accelerating”. If that relationship holds — there could be a clue in the 9 per cent fall in the interest-rate sensitive Nasdaq index so far this year — there is probably a “tough” decade ahead for markets.

All this represents a change of almost paralysing magnitude for anyone used to investing in a long-term low interest rate-driven bull market — one in which even large corrections are more about short-term volatility than long-term loss of capital. Yes, this can happen — see the 1970s.With that in mind you need to do some things differently. You need, as they like to say in the self-help books, to lean into the problem — invest in the things that are causing the inflation rather than just sitting around waiting to suffer from the consequences.The first thing on that lean-in list should be yourself. For the last few decades you have probably felt no particular need to get huffy about your pay. You’ve assumed inflation will knock around 1-2 per cent and you’ve known that the prices of manufactured goods and technology in particular have been falling, so as long as you get the odd promotion, all good.Not so any more. The real value of your income is falling every day. Earn £50,000 today, do nothing and if inflation runs at 6 per cent a year for five years your purchasing power will have fallen to the equivalent of £37,360 today. Central bank governor Andrew Bailey has asked that people refrain from asking for large pay rises. He has a point — in that if everyone asks for an increase we could find ourselves in a nasty wage prices spiral — as in the 1970s. But I’m afraid everyone else is going to ignore him — and you probably should too — note that trade union membership in the UK is rising. If other people’s wages are going to be part of the inflation problem, making sure your own wages keep pace is part of your inflation solution.The second thing on the list has to be your investments in resources: again it is energy and metals prices that are causing much of the inflation — so you need to lean in to them.

Own the problem — preferably in the form of profitable companies which will pay out real money in real dividends. In inflationary times you need returns that beat inflation a lot more than you need fun story stocks. I’ve been nagging you to buy big oil and mining in the UK for some time, so I am not going to go on about Shell and BP (except to say that they are not the enemy and that their average yield is 4 per cent, which is nice) or BHP, Anglo American and Rio Tinto (also not the enemy and offering an average of 6.8 per cent). Instead, I’m going to suggest some smaller names — the good news is that the UK, long considered to be too resources grubby and Brexity for international investors to consider, has hordes of profitable income-producing dividend-paying resources companies that should suit you down to the ground if you are happy to add a little more risk to your portfolio.On the oil side you might look at i3 Energy. Anna Macdonald, a fund manager at Amati, points to its secure operations in Canada, its expected yield this year of nearly 6 per cent and its recent announcement that it is to move to paying monthly dividends to “expedite the return of capital to its shareholders, enabling potential reinvestment and improved returns during a time of market strengthening”.I like the sound of that. You might also look at Atalaya Mining. I suggested this around this time last year and it is up 40 per cent since. Still, it’s probably worth hanging on to it as it has a 5.4 per cent yield and exposure to stable copper production, in a low-risk jurisdiction (Spain).You can make yourself feel better about owning mining companies by thinking of this as “energy transition exposure”.The resource analysts at Berenberg like Atalaya too, calling it copper without political risk. But they also suggest some other interesting ideas. Kenmare Resources is a mineral sands miner with an operation in Mozambique and a policy of paying out a minimum of 20 per cent of after-tax profits in dividends. It is, says Berenberg, “a well-established income stock” on a yield of currently 5.5 per cent. With supply tight and prices rising that is unlikely to change. Polymetal comes with a little extra inflation protection built in, as it’s a gold and silver miner. But it also has some extra risk since its operations are in Russia and Kazakhstan, something reflected in its 8 per cent yield.Finally of interest might be Pan African Resources, a middle-sized gold miner yielding 6.1 per cent, with relatively low debt levels and a portfolio of operations in South Africa.Not everyone wants the risks of holding individual stocks of course. If you want to make your leaning in rather more one-stop shop — and large cap — try the BlackRock World Mining Trust. It yields around 4 per cent and gives you good exposure to the whole mining sector — with a bias towards copper and gold.I particularly like the latter. If there is any part of the argument around market performance that is settled at all it is surely that over the very long-term gold is one thing you can rely on to hold its value. Best to have some. Merryn Somerset Webb is editor-in-chief of MoneyWeek. The views expressed are personal; [email protected]; Twitter: @MerrynSW. She has holdings in Shell, BP, BHP, Rio Tinto, Anglo American and BlackRock World Mining Trust More