Merlea Macro Matters – May 2018

(Merlea Macro Matters)


There remains plenty for the market to ‘worry’ about, with the 10-year bond yield going above 3%, while geopolitical and trade tensions have been elevated. Given the run up in oil prices, inflation must be coming onto the radar. Be all this as it may, investors in my view are placated by the fact that the economy has been progressing well, while the corporate earnings season has been strong. The correction from the highs in late January also took a lot of hot air out of the market and has meant that valuations have moderated.


This could also mean that if we see progress on any of the market ‘headwinds,’ some relief buying could also set in. On this point there was certainly a cooling of US/China trade tensions over the weekend, with US Treasury Secretary Steven Mnuchin saying in an interview with Fox News that “We’re putting the trade war on hold. So right now, we have agreed to put the tariffs on hold while we try to execute the framework.” Mnuchin’s comments coincided with the US and China releasing a joint statement on Saturday in which China proposed to “significantly increase purchases” of US goods. Trade tensions continue to simmer away in the background, but this is really becoming “background noise” which the markets are increasingly choosing to ignore. President Donald Trump referenced that “trade discussions” with China would need to be rerouted and that the current track appeared “too hard to get done” and that “any agreement reached between the world’s two largest economies needed a different structure.” But this was discounted straight away as ‘negotiation’ What has provided sentiment a boost was the Fed releasing their meeting minutes and stating that “interest rates would not be raised at a faster than expected pace”, although a rate hike next month in my opinion is virtually a fait accompli. The minutes stated that “most participants judged that if incoming information broadly confirmed the current economic outlook, it would likely soon be appropriate to take another step in removing policy accommodation”.


President Donald Trump’s move to cancel a planned June meeting with North Korea weighed on the market initially, but sentiment quickly recovered, North Korea is increasingly seen as a ‘non-event’. A key thematic for this year is that global inflation will start to accelerate. While longer dated bond-yields have this week drifted from their new medium-term highs, the bond market seems to be concurring with this scenario. And while meaningful wage inflation in Australia and many other countries has yet to arrive, there are plenty of other catalysts to drive prices higher. Not least of which are rising commodity prices, led by oil.


Global mergers and acquisitions have already reached $2 trillion in 2018, a record for the value of deals in the period according to a report on “Merger Monday” from Thomson Reuters. A flood of deals this month including the $11.1 billion merger of GE’s transportation business and rail equipment maker Wabtec, has boosted corporate activity to a record. The last two periods when M&A activity reached similar levels were in 2007 ($1.8 trillion), and in 2000 ($1.5 trillion), just before the bursting of the bubble of technology and internet related stocks.



The yield on the U.S. 10-year Treasury note has climbed throughout 2018, hitting multiyear highs in an uptrend that is widely expected to continue. The yield is currently at 2.92%, up from 2.24% at the start of the year. The US yield curve is defying the expectations of some of the major investment banks and finally beginning to steepen with longer term rates rising. And the markets are at last beginning to price in the growing risks of future inflation – even though inflationary CPI data has been relatively benign and below the Fed’s target of 2%. According to Goldman Sachs, there is a key yield level for stock investors to watch out for, although it doesn’t believe it will hit that mark in the next couple of years.


“Lower equity prices are not an inevitable consequence of higher rates,” the investment bank wrote in a note to clients. “We expect negative valuation changes if the level of rates approaches 4%, or if the monthly pace of increase exceeds 1 standard deviation (currently 20 bp). Higher yields are seen as making equities look less attractive, a trend that has already been seen in 2018 as investors dump the so-called “bond proxy” sectors. These groups offer both higher dividend yields and greater stability than the overall stock market, but as rates for government paper has risen, it has become competitive with these stocks’ dividends at much less risk. Goldman stressed that the reason yields were rising was as important as the level they rise to. “If interest rates rise in anticipation of faster economic activity, this could lift growth expectations and also lower the equity risk premium,” it wrote. “If rates rise predominantly due to higher inflation expectations, the ability of companies to pass on higher inflation to customers will determine whether growth expectations also increase.”


We expect Australian bond yields to follow global yields higher. Provided there is no sharp sell-off in risk assets we would expect credit spreads and swap spreads to remain well supported.


Listed Property

The sector has been weighed down by the retail AREITs. Going forward, we expect the distribution yield to be just under 5 per cent for the sector, with growth in distributions of more than 3 per cent per annum for the next few years, which provides the underpinning for reasonable returns. Given that pricing is slightly above our longer-term view, we would moderate return expectations down to allow for some reversion. There is considerable valuation dispersion within the sector, providing opportunities for active investors While we are cautious towards the major CBD office markets of Sydney and Melbourne, collectively they are less than 20 per cent of the sector. Perth, Brisbane and Adelaide all have vacancy rates over 15%, and it will take a few years to absorb the current oversupply. Individual investment opportunities will arise, but overall, the markets in all three sectors will be difficult for some time. and an active manager may have less exposure. Retail property represents close to 50 per cent of the sector and as the concerns start to abate we expect it to deliver good returns.


Australian Market

The Australian economy continues to grow and has officially completed 26 years of uninterrupted expansion. We expect the monetary policy easing that took place in 2016 to continue to support a slow but robust growth environment. Over the past six months the consumer has struggled despite a strong business and employment outlook. Corporate profits are robust and business confidence is high, however historically low retail sales and poor consumer confidence driven by very low wages growth makes the outlook for growth in 2018 quite mixed. The Australian 2018-19 Federal Budget proved surprisingly responsible for a pre-election budget with stronger revenue used to drive budget repair in the short term.


Tax cuts and even more infrastructure projects were the main focus, but the immediate tax cuts are just $10 a week for low to middle earners and won’t be accessed until after June next year and the overall fiscal stimulus in the year ahead is basically zero, which is another reason why the RBA may remain on hold.


The downside risks to consumer spending remain with weak wages growth, high underemployment and now falling home prices in Sydney and Melbourne and the Budget not providing much short-term support to households.


Why interest rates may rise; consecutive positive economic data, upward revisions of GDP expectations and downward revisions of unemployment expectations. Why interest rates may remain steady; a current and possible continued lack of wage increase pressures, despite a tighter labour market in Australia, consumer caution and a slowdown of the Chinese economy (in percentage terms, however still anticipated to achieve high growth). Which outcome is more likely will become clearer following the June RBA board meeting.


While the March quarter saw large rises in prices for health, education and utilities weak pricing power is continuing to keep inflation at or just below the bottom of the 2-3% inflation target. Signs of weak underlying inflation remain evident in falling prices for clothing, furnishing, household goods, communication and recreation with private sector inflation excluding volatile items running at just 1.1% year on year


The jobs numbers were something of a mixed bag, with robust employment growth and 22,000 net jobs added in April (ahead of the 20,000 forecast). There was an encouraging 32,000 rise in full-time jobs offset by a 10,000 decline in part-time roles. However, the unemployment rate edged up to 5.6% from 5.5% in March and as the participation rate lifted. It seems there is still some slack in the economy which probably means wage growth will have to wait till the labour market tightens next year. This leaves the RBA potentially sitting on its hands even longer. The data print also places a cap on the $A with 75 cents as the ceiling for now. A weaker $A will provide a tailwind for the economy, with exporters, and the key resource sector benefitting in kind. It could also help nullify the impact of a correction in US$ commodity prices, although I think that the supply/demand equation is strong enough that resource prices could decouple further from the greenback.


Global markets


On the economic front, new applications for US jobless benefits increased more than expected, but the number of Americans on unemployment benefits fell to its lowest level since 1973, pointing to diminishing labour market slack. Other data showed an acceleration in mid-Atlantic factory activity this month, with manufacturers saying they were boosting employment and asking for higher prices for their products.


The combination of a tightening labour market and rising cost of living will serve to boost inflationary expectations – and I think this is going to be a defining story for the second half of the year.


With growth estimates for the second quarter running at around a 3% annualised rate, the stage is set for another solid round of corporate profits results – which Wall Street will soon begin to focus on. This is a stronger foundation for the broader economy than the March quarter, when growth came in at 2.3%. One report from the Conference Board on Thursday showed its leading economic index – which is a gauge of future US economic activity – increased 0.4% in April which follows March with an equal gain.


This is more evidence that points to not just a strong second quarter, but that the economy could continue growing well into the third quarter. I have argued before in these notes that this cycle is different – and extended. But I don’t think the “goldilocks’ scenario of high growth, low unemployment and low inflation will continue. I see a breakout in both the PPI and CPI inflation rates to the upside later this year. And I’m of the view that it is going to be the event that defines the markets in the second half. The economy continues to perform. Reuters had a report out covering results from a recent widespread survey by the Federal Reserve of 8,000 small businesses and 12,000 households. The report confirmed that households “are feeling more stable, and small businesses are making money” and many expect to expand and hire in the coming year, which is indicative of the underlying health in the US economy. One Fed official was quoted as saying “”we see a decided uptick in the economic and credit conditions faced by small businesses”. Manufacturing output – which accounts for more than 70% of industrial production – rose 0.5% as a 2.3% increase in machinery production offset a drop in production of primary metals and fabricated metal products. The positive data followed up Tuesday’s economic data which confirmed a sharp pickup in consumer spending in April. These data prints point to a very firm domestic and global economy which bodes well for the June quarter (of which we are exactly half way through). And industrial capacity utilisation – one measure of how fully firms are using their resources – increased 0.4% to 78%, the highest reading since March 2015. Annualised GDP growth is probably running at around 3%. The only disappointment was poor housing data, which had housing starts dropping 3.7% and building permits falling 1.8%. These numbers could get worse with lumber prices soaring in recent months. We are seeing improved business confidence and improved business performance.

This survey underpins our scenario that the US economy will continue to perform for at least several more quarters, with no sign of a downturn yet in sight.


Stock markets typically plateau and turn down well before an economic recession and many tops occur before there is even “trouble on the horizon”. For now, the stock market is continuing to grind higher “up the wall of worry” with earnings momentum and valuation support for the broader market proving to be the trump card. There is also a healthy amount of scepticism and doubt amongst investors generally about the stage in the economic cycle and where the market is headed, that was absent in January. This leans me towards an upward bias for now with nerves still fragile following the worst corrective selloff in a several years.

We are yet to see the “excesses” and euphoria amongst investors which points to a major top being some way off. There are some signs however that euphoric forces are building. Mergers & acquisitions activity has hit a record high. No major top in the stock market has not been accompanied by feverish deal making, corporate mergers and takeovers. So, the overall message here is that investors need to remain vigilant and open to any changes underlying the market.



In Italy, the populist leftist Five Star Movement and populist far right Northern League look to close to forming government. This was the worst possible scenario after the inconclusive March election given both parties’ background of Euro scepticism and support for irrational economic policies. While it’s marginally negative for the Euro it’s not an immediate threat, but it will slow a Macron-led move to a more integrated Eurozone. And for Italy it risks a renewed deterioration in the budget deficit and an undoing of structural reforms which is negative for Italian shares and bonds. That said, the more extreme 5SM and League policies are likely to be softened down a bit in government and in any case, politics is often a mess in Italy. In economic news on the continent, minutes from the ECB’s (European Central Bank) last policy meeting indicated that its members view the recent slowing of growth as due to mostly temporary factors, while underlying price pressures were viewed as still relatively weak. They also warned that uncertainty regarding the outlook had increased. Data from Eurostat showed that as estimated, Eurozone inflation eased slightly in April, slowing to 1.2% from 1.3% in March. The rate came in line with the earlier estimate. Eurozone trade surplus rose month-on-month in March as exports increased faster than imports according to Eurostat data. The seasonally adjusted trade surplus edged up to €21.2 billion in March from €20.9 billion the month before


In Germany, producer price inflation edged up to 2.0% in April from 1.9% in March, differing from expectations for the pace to slow to 1.8%. House price rises are bubbling in the major cities and early signs of wage pressures are emerging too. Germany’s biggest trade union, IG Metall, is threatening all-out strikes unless employers meet demands for an eye watering 6 per cent pay hike this year. It could trigger copycat pay demands across Germany and other euro zone nations. Maybe Germany could cope with higher wage inflation thanks to its strong productivity record, but it would be a disaster waiting to happen across the euro zone if higher pay demands catch on, especially in the low productivity, distressed economies after a decade of enforced austerity. European inflation would return with a vengeance.



In the UK, Wages are rising at their fastest rate in three years as a strong jobs market and growing skills shortages force employers to improve pay.


Average wages rose by 2.9pc in the 12 months to March. This would represent an acceleration from 2.8pc in February and comes at a time of falling inflation. Bank of England governor Mark Carney reportedly defended the central bank’s decision to leave UK interest rates unchanged, saying a rate increase was never “set in stone.” This month British households have become more optimistic about their financial situation according to the IHS Markit Household Finance Index, which increased from 43.4 in April to 44.7 in May. That is the highest level since the end of 2016. IHS Markit economist Sam Teague said, “a welcome combination of rising incomes, falling inflation perceptions and fading concerns around job security all contributed to the strongest HFI survey results in nearly a year-and-a-half.”


UK retail sales swung back higher in April after a decline in March according to data from the Office for National Statistics (ONS). April UK retail sales volumes increased 1.6% from March, when sales volumes had declined 1.1% due to a cold snap. The 1.6% pace was well above the forecast for a 0.9% monthly increase. Petrol sales bounced hard (+4.7%) after a sharp 6.9% decline in March due to road closures. Core retail sales increased 1.3% month-on-month.

Still, Rob Kent-Smith, Head of National Accounts for the ONS was relatively downbeat on the data, saying, “Retail sales bounced back in April, as petrol and other sales recovered from the snowfall. But the underlying position remains subdued with the volume of goods sold over the last six months broadly unchanged.”



First the good news, wages in Japan seem to be finally on the rise. According to the preliminary wage report for March 2018, regular wages in Japan rose by 1.3% year on year (YoY), accelerating from 0.6% YoY in February and reaching the highest rate of increase since July 1997. There have been a few false dawns for a wage inflation in Japan, but the current rise may be a real one. Many Japanese companies have struggled to find employees as the jobless rate has fallen to 2.5 percent in March, near the lowest since 1993. This has pressured businesses to raise pay and offer more permanent positions to secure the workers they need. The view of the Bank of Japan has been for so long that an annual inflation rate of 2% is just around the corner. One problem for the BOJ is that inflation, though still modest, is already eating into workers’ pay increases, as seen in the 0.8 percent gain in real wages in March. The central bank also points to businesses cutting hours and investing in labour-saving technology as reasons for slow progress on inflation.


Fresh data showed the Japanese economy contracted more than expected in the first quarter. GDP fell 0.6% on an annualised basis for the January – March quarter, ending eight straight quarters of expansion which was the longest run since the 12-quarter run between 1986 and 1989. Trump administration is closely looking at car and truck imports and considering new U.S. tariffs. The United States has long been a major export market for Japanese automakers and in Japan there is a large ecosystem of companies supporting the big carmakers. With the rise in US Treasury yields, exporters benefitted from a modest dip in the yen and energy stocks were supported by crude prices. It was a quiet day for regional economic data, but in Japan core CPI inflation in April of 0.7% was below the 0.8% estimate. Non-core CPI was just 0.4%, in line with expectations. Japan’s core machinery orders fell in March for the first time in three months, but manufacturers still forecast a rise for April-June, indicating capital expenditure could hold up despite news that the economy contracted in the first quarter. The 3.9% fall in core orders was worse than the 3% forecast by economists in a Reuters poll. However, manufacturers surveyed by the Cabinet Office forecast that core orders will rise 7.1% in April-June, after rising 3.3% in the previous three months and up for a third straight quarter.


I see the Japanese economy returning to growth this quarter (led by exports and capital expenditure) with Japan leading the world in growth sectors such as factory automation and robotics.



China’s Politburo meeting was interesting with talk of stimulating domestic demand with no reference to deleveraging. It’s premature to expect a significant stimulus – growth is not weak enough (6.8% in the March quarter) and the Government is still aware of issues around debt – but it reinforces the view that a significant slowing will not be tolerated. Chinese President Xi Jinping struck a conciliatory tone, saying China would “significantly lower” tariffs on vehicle imports, allow more foreign investment in certain industries, better protect intellectual property and boost competition in a bid to further open its economy to the world. Central bank governor Yi Gang was reported to have said that China will allow more foreign investment in the financial sector over the next few months. China-Hong Kong connect quotas will be increased.


Chinese trade data remains consistent with continuing solid growth with export growth rebounding to 12.9% year on year in April and import growth rising to 21.5%. Credit growth came in a bit stronger than expected in April with annual credit growth around 12% and again consistent with solid economic growth. China’s trade surplus with the United States surged almost 20% in the first quarter, which some attributed to exporters pushing shipments out early to get ahead of threatened tariffs. The surplus with the US increased 19.4% to $58.2 billion in 1Q18, while China recorded a deficit of $9.9 billion with the rest of the world during the quarter.


Meanwhile, CPI inflation fell to 1.8% year on year from 2.1% but with core inflation running along at 2%. So, nothing to get excited about here. Official data showed Chinese inflation eased in March as demand dipped after the Lunar New Year holidays. Consumer prices in China were up 2.1% year-on-year in March, which was below the 2.6% expected and down from 2.9% in February. Meanwhile, producer prices were up an annual 3.1%. That was also below economists’ expectation of 3.3% and the 3.7% reading in the prior month. Because China is such a significant global exporter, the lower Producer Price Index should ease any inflationary pressures in other countries. In other words, China is exporting less inflation.


The coming months overseas will be very revealing as we will get a better fix on the Chinese economy, at least in terms of growth numbers. What remains opaque is the health of China’s financial sector, that remains a significant concern.



We believe that the recovery in commodity prices that started in early 2016 and paused in 2017 is likely to continue in 2018. Underlying supply and demand balances are increasingly positive in key energy, metals and select agricultural markets. Importantly, the structural outlook for the Australian dollar looks increasingly weak, while global inflation has likely bottomed.


Commodities remain stuck “out of fashion” in the sentiment cycle, characterised by underweight investor positioning. Few investors have any proper inflation hedge in their portfolios. With the improved market outlook, it is in our view time to reassess exposure to such inflation-friendly asset classes as commodities. The rebalancing of the industrial metals sector has been proceeding quickly, and prices have strengthened. However, the transition of the Chinese economy to slower, cleaner, less “dirty cyclical” growth has capped my enthusiasm for some metals for now. I am looking for price stability and we believe profitability should improve. Commodity prices are likely to continue contributing to modest rates of inflation, even with some near-term downside pressure because of the unstable global trading environment. We do not expect the commodity complex other than oil to deliver any kind of material inflation shock over the next 12-18 months.



Against a backdrop of increasing geopolitical and financial market volatility, gold and silver’s solid track records as liquid and easily transferable tangible assets that have long been considered as a currency of last resort, may come increasingly onto investors’ radars


The US Fed meet is coming up on June 13. Since the Fed is expected to raise rates, it is reasonable to think that another gold low cycle will come by before or during June. There has been classic “sell during rate hike expectation and buy after rate hike event” in nearly every case since Fed started raising rates


Australian gold producers are also benefitting from the A$ gold price being near record levels, with the RBA someway behind the Fed – in terms of tightening monetary policy – more weakness in the A$ could provide a further tailwind for the sector. Gold pushed back above $1300 to settle at $1304 with silver posting a 1.4% rise. Overall, I think that the precious metals have performed quite well given the rebound in the US dollar. We are sticking to our base case of the gold price breaking out above $1400 later this year as inflation becomes more obvious within the global and US financial systems.



The energy sector contributed to the market closing in the red after OPEC said it may pump more oil to compensate for supply contraction in Venezuela and the impact of possible sanctions in Iran. Key producers are comfortable with oil at these levels, Saudi Arabia has expressly said as much, with one eye on the IPO of Aramco next year. Other countries where oil is the main driver of export revenues, such as Venezuela and Russia, will also be quite comfortable with current price levels.

We are seeing shale activity step up, but this will take time to make a difference. US distribution infrastructure remains constrained and this is effectively capping drilling activity, which is why the drill rig deployment rates have not climbed higher. The prospect of higher drilling and exploration should however put a lid on US$100 plus oil. Triple digit oil prices of course played their part in the GFC, and a ‘goldilocks’ price of around US$70-US$90 will be something the global economy can cope with. It will also be enough to underpin inflationary pressures, for the Australian producers a softer local currency will also be boosting revenues.

Sector 12 Month Forecast Economic and political predictions 2018




The weak A$, (which looks to be headed lower) will be positive overall for the economy, still a little overbought.

72c -80c


A$ the weakness in the currency this year has certainly been pronounced, with a move from around 81 cents versus the US dollar, to just under 76 cents currently (and reaching a low of US$75.05 at one point). The decline in the A$ has coincided with US dollar strength and longer-term interest rates pushing up to medium term highs. Interest rate differentials and higher growth prospects in the US are propelling the greenback up against the Aussie and other major currencies.


Some are clearly betting on further Aussie dollar weakness. The latest US Commodity Futures Trading Commission data revealed that institutions have extended their net short Australian dollar positions to a record high 47,700 contracts as of May 15. Near term this could mean that a bounce may be overdue with short position covering likely to ensue on any economic data or rhetoric that suggests the RBA could tighten earlier. I don’t think however this is really the base case, with the RBA caught between a patchy economy, rising unemployment and a weaker residential housing market.


In my view the Fed will remain some way ahead of the RBA in its rate tightening program. We are on record for calling for four rate hikes by the Fed this year, while a tick-up in the unemployment rate and benign inflation have likely pushed a move by the RBA well into 2019.




With bond yields rising, gold could get a bid as a safe harbor asset, especially with price trends improving.


Sentiment in the gold market appears to be shifting as prices hold on to critical support at $1,300 an ounce, bouncing off fresh five-month lows at the start of the week. The Federal Reserve’s monetary policy meeting showed that committee members support inflation moving past their 2% target in the near-term. Also helping gold prices is a resurgence in geopolitical uncertainty after President Donald Trump cancelled the June 12 meeting with North Korea’s leader Kim Jong-un. June gold futures settled the week at $1,303.70 an ounce, up almost 1% from last Friday’s settlement.




Overweight energy and materials.


Commodities historically have tended to do well in the later stages of a business cycle. Unlike equities, which often anticipate changes in growth and earnings, commodities are more rooted in the present and tend to perform well once capacity constraints are already developing.




A-REITS that focus on specific market “niches”, such as properties in the education, health care, aged care, and agriculture market. These sectors not only have strong long-term tail winds behind them, they are for the most part, recession proof.

Increase weightings


Listed property markets remain weak. Rental yields are still low and prices are still high even after property trusts sold off late last year.




Australian Equities


We should begin looking at consumer staples and healthcare for equity investments. Some Value emerging in the banks

5580 – 6600


We have been expecting a reality check for a while and have been surprised by the uninterrupted strength of many markets over the last 12 months. While the Australian share market will weaken in line with overseas markets, we believe the main pain will be felt in areas such as the resource sector and all the speculative smaller stocks. The Australian market could well spend a period consolidating the gains since early April. We remain of the view that this will set the stage for a concerted push higher, with a weaker $A, higher commodity prices (wool was the latest commodity to make new record highs), and a widening disparity with US interest rates being the primary drivers.




A rising rate environment means we should shorten our duration for bonds.


For the bond curve, we expect a modest steepening over the remainder of 2018. Yields on 3 year bonds will be anchored near current levels until markets start pricing in a rate hike from the RBA more aggressively. The 10 year leg will be influenced to a greater extent by US Treasuries and so should rise.


Cash Rates


The RBA on hold.


Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.70%.

Global Markets



Underweight US.

S&P 500: 2580 -3100


The S&P500 encountered resistance at 2,670 last week. Our scenario is for the index to break through this level on the upside in April and run to 2750/2800 with a strong quarterly reporting season being the probable catalyst. However, it may take some time before new record highs are attained above 2,850.




Our preferred sectors – autos, telecoms and banks – are ones that have suffered in the low-rate environment of the past few years and now look very cheap.



We expect economic growth to continue to consolidate but to remain at a high level.

• Inflation should start to rise firmly again, driven by base effects and higher oil prices.

• We expect the ECB to end its QE program in 2018 and to start raising rates in mid-2019.




Overweight once a correction has occurred.

Nikkei 225: 21500 – 2500

Favour Japan.


I expect Japan’s stock market to continue climbing a “wall of worry”, even though the underlying economy, labour market, along with the export and manufacturing sectors, are in the best health in decades. Japan’s stock market is in the early stage of a secular bull market. Valuations are still very compressed. Japan’s economy is only just emerging and reenergising after a multi decade deflationary slump.





Shanghai Index: 3350 -3650


GDP growth should moderate this year, but the quality of growth should be better. Monetary policy should remain prudent, with further regulatory tightening. Political, economic, and currency stability should keep investors confident on China.


Source: Merlea Investments


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