2021 CAPITAL MARKETS FORECAST
The Economy and Capital Markets in a Changed World UNCOVERING OPPORTUNITY ON THE ROAD AHEAD
WELCOME TO OUR
2021 Capital Markets Forecast The research and insight within this forecast serve as the foundation of our investment process. It informs the customized portfolio strategies we design to help each of our clients increase the probability of reaching their individual goals by maximizing risk-adjusted returns.
With the shock and aftershocks of the global COVID-19 pandemic, 2020 was a year unlike any other in history. It was turbulent, fascinating, frightening, and at the same time it showed us many timeless truths about the economy, the markets and humanity. As we turn our eyes to 2021, none of us can predict the future, but we can rely on time-tested research methods and innovative thinking to move forward thoughtfully together.
Contents The Balentine Building Blocks
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Uncovering Opportunities on the Road Ahead
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Thinking Differently About Income
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What’s Ahead for 2021
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Appendix 28
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The Balentine Building Blocks As we consider near-term and long-term portfolio strategies in the context of our 2021 projections, we continue to base our portfolio strategies on several foundational building blocks. Foremost, our investment philosophy is to create portfolios that meet clients’ needs while taking the least amount of risk required. The greatest risk to a portfolio is the permanent impairment of capital. We seek to lower this probability by managing liquidity needs and drawdown tolerance. Rather than viewing the total portfolio as a division of assets among primary asset classes (i.e., stocks, bonds, cash) or by the characteristics of the securities underlying those asset classes (i.e., growth, value, domestic, international), we choose to manage those factors by categorizing assets based upon their underlying risks. Our primary building blocks are comprised of the following: Liquid assets protect near-term spending capacity.
It’s important to reinforce that we choose to create our portfolio strategies based on these building blocks, rather than the more simplified model of pure asset classes. This is because not all bonds, stocks or other investments are created equal. A bond, for example, should be considered for both its market risk and liquidity characteristics. In contrast, a very stable equity—while a risk asset—could serve the purpose of a fixed-income instrument. We discuss our portfolio strategies later in this document. With each investor we serve, we consider these building blocks within the context of their unique financial and personal situation.
Helpful Definitions Throughout this forecast, you’ll see a few terms which are more technical in nature for some readers. Below are simple definitions for reference:
short-term duress.
Asset market – the set of markets in which investors buy and sell real and financial assets, including gold, houses, stocks, bonds and money.
Market Risk assets seek to capture broad
GFC – Global Financial Crisis
Fixed Income assets protect against
market returns. Alternative assets provide additional diversification to portfolios with relatively limited correlation to equity and fixed income markets. Private capital assets aim to achieve excess long-term returns and provide insulation from volatility in broad financial markets.
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Secular – refers to market activities that occur over the long term and tend to be relatively unaffected by short-term trends. A secular stock market is the market’s overarching trend or direction (upward or downward) for five years or more. Risk
asset – any asset that is not risk-free
Russell 2000 – commonly referred to as “small cap stocks,” is an index measuring the performance of approximately 2,000 American companies with market capitalization between $1 billion and $4 billion.
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Uncovering Opportunities on the Road Ahead Bringing context to 2020 volatility and complexity 2020 was one of the more volatile years in recent history for equities, as the market dealt with the potential impacts of Coronavirus. The daily volatility, as measured by standard deviation of large cap US stocks, was 37%—surpassed only by the uber-volatile year of 2008 (Figure 1). Note that the years with volatility in excess of the 30-year average each had a significant triggering event.
Figure 1. 2020 was as volatile a market as we have seen in the last 30 years, surpassed only by 2008’s epic volatility and the Global Financial Crisis. Year
Volatility
Event
2008
40.9%
GFC Crash
2020
36.9%
COVID-19 Crash
2009
27.6%
GFC Crash
2002
25.7%
Internet bubble bear market end
2011
23.7%
U.S. debt downgrade
2000
23.1%
Internet bubble bear market onset
2001
22.0%
Internet bubble bear market ongoing
1998
19.9%
Asian debt crisis
1991–2020
18.3%
2010
18.2%
Bull market
1999
17.6%
Bull market
1997
17.1%
Bull market
2018
16.9%
Bull market
2003
16.8%
Bull market
2007
15.8%
Bull market
2015
15.3%
Bull market
1991
13.6%
Bull market
2016
13.3%
Bull market
2012
12.9%
Bull market
2019
12.5%
Bull market
1996
11.6%
Bull market
2014
11.5%
Bull market
2013
11.1%
Bull market
2004
11.1%
Bull market
2005
10.3%
Bull market
2006
10.1%
Bull market
1994
9.6%
Bull market
1992
9.3%
Bull market
1993
8.5%
Bull market
1995
7.8%
Bull market
2017
6.8%
Bull market
Source: FactSet
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Note that the crashes, in general, are worse than the typical bear markets. Typically, crashes occur in the middle of bull markets, where stocks are not overly expensive compared to bonds. The catalyst for the crash runs its course, and the bull market continues. Eventually stocks become so expensive, that the ensuing downturn is typically not a crash but instead the onset of a bear market.
What are we to make of what we endured in early 2020? Crash or bear market? Recession or no recession? The answers to these questions are not simple. A bear market is traditionally defined as a decline in stocks in excess of 20%. Historically, however, bear markets have been a function not only of magnitude, but also of duration, with sustained periods of decline. Using the traditional definition would encompass a number of short, deep declines that were not prolonged periods of decline and did not end up derailing the ongoing expansion or equity bull market. To better answer this, we hearken back to our two key points in our discussion of the economic cycle that we outlined in our 2019 Capital Markets Forecast. Recall our economic cycle piece discussed: • The typical cycle begins from a trough in both the economy and the capital markets. • Capital markets usually move in advance of the economy because changes in expectations flow through to asset pricing far more quickly than they flow through to a change in economic activity. As the cycle progresses and slowly but surely vanquishes behavioral and capital markets headwinds, strength gathers in the economy. This leads companies to surpass expectations, which
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in turn drives further growth in capital markets and the economy. As both capital markets and the economy deviate too excessively from the trendline, both the economy (in the form of contraction) and markets (in the form of bear markets) adjust until the excesses are whittled away. Then the cycle begins anew. What we saw in 2020 was like nothing we have seen historically in the economy or the markets. It was a combination of a solid recovery with decent growth, reasonable earnings expectations, a lack of excess from consumers and corporations, and an absence of investor exhilaration—the sum total of which was flattened by a virtual meteor no one saw coming. So, what is the practical difference between this cycle and prior cycles? Quite simply, because the crisis was brought about by the exogenous shock of a pandemic rather than cyclical excesses, it is less likely that the usual prescription of low interest rates and excess liquidity will restart the economy despite the positive impact we’ve seen in the markets.
We believe there are three important takeaways to focus on going forward: 1. The economy and the markets are not one and the same. One can excel while the other is languishing.
2. “Creative destruction,” in which new technologies replace outdated ones, is a healthy part of capitalism despite the short-term turmoil it invariably creates. Markets can see through this and tend to adjust to it naturally.
3. Liquidity is a dominant factor, if not the most dominant factor, driving markets. Markets are likely to head higher on the back of liquidity before the next bear market ensues.
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Drawing Distinctions: The Economy vs. the Markets There is a larger and more frequent disconnect between the economy and the markets than many would think. The fact that one can walk down the street and see small businesses such as restaurants, drycleaners, personal trainers, auto repair shops and animal groomers leads one to erroneously overvalue the significance of these businesses, not only on the stock market but also on the economy. That is not to say they are not important. They simply lack the scale to move markets and the economy the way companies like Microsoft, Apple, Amazon, Alphabet, Netflix, Visa, Mastercard and others can. This idea has been addressed in countless ways. One particularly good example is a Bank of New York study that showed during 1970–2012 the correlation between quarterly gross domestic product (GDP) and S&P 500 price change was
only 12%. Moreover, the amount of change in the S&P 500 specifically attributable to the rise in GDP was a mere 1.5%.1 One may think that because capital markets move in advance of the economy, we could expect a higher correlation with GDP in the subsequent quarter rather than the concurrent quarter. This timing mismatch between investor returns and economy cash flows occurs because part of economic expansion results from savings being invested in capital rather than being spent on consumption. The gains resulting from those capital investments accrue to future shareholders, not existing shareholders. So, while it is true that there is an increased correlation with the subsequent economic period, the increased correlation of 28% remains relatively insignificant.
Stock Markets vs GDP Growth: A Complicated Mixture, July 2012
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Think of the relationship between the economy and the stock market as similar to the relationship between a boat and a skier being pulled by that boat: they will, over the longer term, trend in the same direction and will be tethered to each other. But over any short-term period, they can be moving in different directions, in different magnitudes, and at different velocities. Let us examine both the economy and the markets, in turn, with the understanding that they are not one and the same.
THE ECONOMY It’s important to set context before diving into an analysis. The 2020 Q2 GDP was reported to have declined 31.4%, only to be followed by a 33.1% rebound in Q3. These are shockingly large numbers in magnitude, but it is crucial to remember that GDP is reported as an annualized number. In truth, the decline in Q2 and rebound in Q3 were actually closer to 9% in actual GDP dollars.
Annualizing numbers can make quarterly figures look far more extreme than they actually are, both on the downside and on the corresponding upside. This is still a stunningly large decline, but it does take some of the edge off the headline number and ameliorate the magnitude of what seemingly occurred during the year.
The takeaway here is that the standard methodology of annualizing quarterly numbers can provide an appropriate annual perspective during “normal� quarters, but it is not practical for extreme circumstances such as what we experienced in 2020. With that said, concerns about deflation over what was still a severe economic shock drove the Federal Reserve to institute extremely loose monetary policy (far looser than anything experienced in our lifetime) between their interest rate policy and newly created liquidity facilities. This will continue to impact the economy somewhat. However, we need to see a more robust transition to fiscal policy in order to bring about a greater recovery in the overall economy. This is because monetary policy tends to have a disproportionately larger impact on the financial markets than the economy, whereas fiscal policy tends to have a larger impact on the economy.
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Expected winners and losers in 2021 WINNERS
✔ Technology companies ✔ Work from home (WFH) companies [companies that enable remote work]
✔ Sanitizer producers ✔ Psychiatrists
The Federal Reserve’s 2020 insistence that the central bank intends to keep rates low for a long time in order to support the economy amid pandemic shock (to quote Chairman Powell’s doubly emphatic, “not even thinking about thinking about raising rates”) means more financial repression for savers and more encouragement to take on leverage for spenders, businesses, and investors. It also most likely means businesses that are winners should take on more leverage to generate a higher return on equity if they are seeing commensurate demand for their products or services.
✔ Online and big-box retailers ✔ Video game companies ✔ Homebuilders LOSERS
✘ Hospitality and leisure (most notably airlines, cruise lines, hotels, casinos, live entertainment, movie theaters and theme parks)
✘ Department stores ✘ Restaurants ✘ New York City
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It’s critical to bear in mind that leverage is a two-sided coin. Business owners should be very confident in the direction of their business before taking on extra leverage. Just as leverage will magnify financial benefits on the upside, it can also greatly magnify poor returns on equity to the downside. But this higher leverage is less likely to cause systemic problems like it did in 2007, when we saw widespread overleveraging among businesses and individuals. This is because many businesses are lacking the top-line demand to take on leverage in the first place, and so many businesses and individuals are still jaded and have lingering debt aversion from the GFC.
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Inflation, deflation — or both? Technology is moving at light speed, which is deflationary. However, commodity prices and recent rises in interest rates are hinting at a future that is inflationary. We may actually see both, given the large disparity in winners and losers and the velocity of money crashing for losers and accelerating for winners. It will ultimately depend where all the money flows. Unlike prior contractions, when velocity of money slowed consistently across all sectors of the economy, with only minor differences among different companies and sectors, this contraction saw money effectively rerouted from one set of companies (the “losers”) to another set of companies (the “winners”). This strong divergence between the winners and losers was historic. Winners saw revenues and stocks explode, while losers saw revenues and stocks collapse and they also endured many bankruptcies.
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The cyclical nature of history and creative destruction Every generation feels as if they are experiencing fulcrums in history. Yet while it often feels like “life will never be the same” in those moments and for a short time thereafter, the reality is that life may change but the economy is rarely impacted structurally. One example is airlines after 9/11. The flying experience was and remains quite different after that event. Security measures have evolved, non-passengers are no longer allowed in gate areas and technology used by the industry has evolved. But airlines and their basic industry dynamics have stayed essentially the same. Even after the demise of many worthless companies in the bursting of the internet bubble, the economy remained structurally sound and continued to move forward. Perhaps many estimates of the eventual greatness and strong impact of those companies were just 20 years ahead of their time. Within an economy, old companies die out and new companies are born. This is what economist Joseph Schumpeter coined as “creative destruction.”
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While there are some large companies that stand the test of time such as Cigna (founded in 1792), DuPont (founded in 1802) and ColgatePalmolive (founded in 1806), the reality is that most companies eventually die out or evolve into something else. That’s because the engine of capitalism is constantly innovating products and processes to drive productivity and efficiencies that serve to replace archaic production methods and end products. In doing so, a great deal of excess capacity is produced in the short run as a result of capital investment to drive productivity upgrades. Such upgrades are a large portion of the investment component that comprises GDP growth, and they allow the economy to transition and continue to grow while the excess capacity is amortized away permanently. An important distinction regarding excess capacity brought about by creative destruction vs. excess capacity during a standard cyclical slowdown is the way in which such excess is reduced. Cyclical slowdowns affect temporary levels of excess capacity that merely need to be whittled away via population growth and productivity improvements. An ideal example is the housing surplus after the GFC. There was going to be an eventual need for homes as the population grew and as family formation resumed after the recession; the eventual return in demand was a just a matter of time. In the meantime, homebuilders adjusted by scaling back for some time. In the case of the fallout from the pandemic, however, there is capacity for which demand may never return as the economy
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secularly transitions. This will take time, but the economy as a whole always ends up better off in the end. Consider the change in the components of the Dow Jones Industrial Average (DJIA) in the last 50 years. The change, not only in the companies themselves but also the sector composition of the index, shows how the economy has changed from a hard-asset, capital-intensive economy to a capital-light technology base in a relatively short period of time. This is very much a result of creative destruction rendering many companies and industries obsolete. Another example potentially coming to a head is the energy sector. Although the energy sector is showing a rebound to end 2020 after a cataclysmic decline during the pandemic, it raises an important question:
Has improved technology and efficiency in the sector (which has had a positive effect on the overall economy in the form of lower input cost) simultaneously put the industry on the path to obsolescence? This obsolescence would be the result of structurally lower fuel prices in perpetuity resulting from permanent improvements in extraction methods and a growing shift to alternative fuels. In fact, look at all the household names in the index today that that were not in the Dow Jones Industrial Index 20 years ago, much less 50 years ago (Figure 2).
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Figure 2. The DJIA composition has undergone almost a complete turnover during the last 50 years… 1/1/71
1/1/21
Figure 2 (cont.) …with many sector changes over the last 20 years as well.
1/1/01
1/1/21
Chevron
3M
Procter & Gamble
American Express Boeing Caterpillar Coca-Cola Disney Home Depot Intel IBM Johnson & Johnson JP Morgan McDonald’s Merck Microsoft Procter & Gamble Walmart Alcoa Amgen AlliedSignal Apple AT&T Chevron Citigroup Cisco DuPont Dow Eastman Kodak Goldman Sachs Exxon Honeywell General Electric Nike General Motors salesforce.com Hewlett Packard Travelers International Paper UnitedHealth Group Philip Morris Verizon SBC Communications Visa
Allied Chemical
3M
Alcoa American Can Company
American Express Amgen
Anaconda Copper
Apple
AT&T Boeing American Tobacco Caterpillar Bethlehem Steel Cisco Chrysler Coca-Cola DuPont Disney Eastman Kodak Dow Esmark Goldman Sachs Exxon Home Depot General Electric Honeywell General Foods Intel General Motors IBM Goodyear Tire & Rubber Johnson & Johnson Inco Limited JP Morgan Chase International Harvester McDonald’s International Paper Merck Johns-Manville Microsoft Owens-Illinois Nike Sears Roebuck salesforce.com Texaco Travelers Union Carbide UnitedHealth Group U.S. Steel Verizon United Technologies Visa Westinghouse Electric Walgreens Boots Alliance Woolworth
United Technologies
Walmart
Walgreens Boots Alliance
Sector
1/1/71
1/1/21
Δ
Sector
1/1/01
1/1/21
Δ
Consumer Discretionary Communication Services Consumer Staples Energy Financials Health Care Industrials Materials Technology
5 1 4 3 0 0 9 8 0
4 1 4 1 4 4 3 2 7
(1) 0 0 (2) 4 4 (6) (6) 7
Consumer Discretionary Communication Services Consumer Staples Energy Financials Health Care Industrials Materials Technology
3 2 4 1 3 2 8 3 4
4 1 4 1 4 4 3 2 7
1 (1) 0 0 1 2 (5) (1) 3
Source: Dow Jones
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Source: Dow Jones
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There is absolutely no precedent for 2020. The best any experts can do is to make a best-effort attempt to interpret what has occurred and may lie ahead. Our interpretation is that rather than a protracted bear market, what we have experienced is an ultra-accelerated cycle that cleansed out certain aspects of the economy while sharply boosting others. Put differently, the forces of creative destruction ran their course quickly. The shift in spending patterns since early 2020 has brought about creative destruction more quickly than typical and does seem to show evidence of more permanence than we would normally see. That’s because consumer behavior patterns have changed and continue to change in the aftermath of COVID.
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Acceleration of creative destruction in the form of expanded innovations (most notably in technology), has been reflected in capital moving from archaic technologies and industries and into those that are generating productivity improvements. This is happening at a rate not seen in decades, if ever. The key question is whether we are seeing once-a-century or twice-a-century advances— like the cotton gin, internal combustion engine, light bulb, telephone or internet—which will drive productivity trends permanently higher. Our default hypothesis is that this is indeed the case, but this will be known with certainty only in hindsight.
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Another timely example of creative destruction are the innovative work-from-home and play-from-home technologies which are likely here to stay, upending our reliance on many structures previously deemed to be irreplaceable. Think offices, hotels, airlines and gyms. That is not to say these will disappear entirely, but suddenly a great deal of excess capacity has surfaced, and the landscape may never look the same. And what will be of industries such as commercial real estate, for example? As one of the most highly affected industries in the wake of the pandemic, questions swirl about what’s next on this front. A few possibilities to consider: Offices: They’re not going away completely. Companies may need more office space (so that the same number of employees will be able to fit into more space in order to allow for adequate social distancing). Or they may need less office space because of a permanent, widespread shift to working from home. The situation is very fluid at the moment, and it will take some time for clarity to emerge here.
Retail space: Even though retail sales have been slowly shifting online for years, COVID caused a dramatic shift toward online and away from physical retail shopping. Like offices, retail spaces will not vanish; however, the leap in online sales naturally means less brick-and-mortar will be needed while there will be greater need for storage and distribution centers.
Medical building: Healthcare represents 20% of domestic GDP, and the advent of telehealth is fundamentally changing how medical practices deliver services. And surveys show that patients prefer the efficiency and appreciate not having to drive, park and wait in crowded waiting rooms only to spend a few rushed minutes with a doctor. Given these facts, signs point to the telehealth trend continuing. Creative destruction could mean these places end up as distribution centers, data centers, or perhaps even storage facilities if oil surpluses reassert themselves. The only certainty is that more changes are coming. What’s uncertain is which ones and how long they’ll last. As noted previously, some ongoing change is a normal part of capitalism. But necessity is the mother of invention. And in a post-pandemic world, changes such as technology adoption are being compressed into an entirely new time scale of months and weeks rather than years.
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THE MARKETS In the shorter term, while we do not want to say the markets have looked totally past COVID, they have been pricing in better-case scenarios for a while now. At this point, there are reasonable bear cases and bull cases to be made:
Bear scenario: • While the economy did bounce back in Q3, it is still dealing with the effects of the greatest quarterly decline in history. Though the end of the pandemic is in sight as vaccine developments keep progressing, the virus is still not under control and additional spikes continue to make it more challenging to fully open many segments of the economy.
Bull scenario: • Short-term interest rates of zero will likely continue to feed through to asset prices via both an increase in the discounted value of future cash flows as well as investment flows into equities. Liquidity increases will provide a bridge for people and businesses. The Fed has committed to long-term support (as mentioned earlier, the Fed governors are “not even thinking about raising rates”). • Ultra-loose monetary policy will lead to more financial repression, with low interest rates for the foreseeable future. But individuals with assets are in good shape, just as they were in good shape after the GFC, when risk assets were also rewarded. Investors are scared about retirement and their ability to generate adequate income because of the effect of financial repression on the income levels that come from traditional bonds. While an argument can be made that total return (i.e., capital gains plus income) is most important, psychologically it is hard for investors
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to move from spending income to spending total return because income is predictable—whereas total return is not. (In general, individuals are naturally afraid to spend capital gains.) Note that we explore in later pages of this forecast why we believe the emphasis should be on total return. • Tax policy moving forward is uncertain, but it is going to take time to reveal itself regardless of the results of the Senate election. So, any tax concerns will be on the back burner for a while and should have little effect on the markets and tax planning in the near term.
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High notes in the market As we examine markets on the back of the great rebound from the COVID low, four themes become evident:
Stocks are not expensive relative to bonds or historic valuation multiples. With bond yields as low as they are now (up from their Coronavirus lows but still extremely low by historical standards), there is still much room for them to rise before stocks could be considered expensive relative to the yield level. In terms of historical valuation multiples, the S&P 500 had a cyclically adjusted P/E ratio (CAPE ratio) of 45.8 at its peak in 2000, at a time when the 10-year Treasury yield was 6.25%. With the current 10-year Treasury yield hovering under 1%, the current CAPE ratio stands at 32.4. So, at the current level of 10-year earnings, the S&P 500 would have to trade at 4300 to match the CAPE ratio of March 2000. And, of course, earnings will grow as the economy rebounds from the recent stresses.
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If we look at valuations on current earnings vs. cyclically-adjusted earnings, the question becomes this: What is the appropriate earnings yield of the U.S. stock market (i.e., the reciprocal of the P/E ratio) at the current level of interest rates? We would argue there is certainly the potential for valuations to expand further. The standard formula for the P/E ratio as represented by the present value of a perpetuity is 1/(r-g), where r represents the discount rate and g represents the growth rate. So, for example, if the appropriate discount rate is the 10-year Treasury (e.g., ~1%) + a historical risk premium (e.g., ~3%), and we assume a relatively modest earnings growth rate in perpetuity of 2%, then our earnings yield would calculate to 1/(1%+3%-2%). This would calculate to a P/E of 50 or an earnings yield of 2%.
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NOTE: We are not definitively calling for the index levels or valuation levels previously cited. Rather, we are merely pointing out that getting to such levels using fundamental analysis is by no means a stretch. In summary, the equity markets could conceivably go a decent amount higher before our model and history would consider the market to be sufficiently expensive to predict an imminent bear market.
Market trends look like early cycle. As 2020 comes to an end, the trends in the market are most historically aligned with early-cycle trends. This buoys the theory that COVID served as a catalyst for the creative destruction that has given rise to new companies and technologies that will drive the bull market higher. We currently see strength in small cap equities, financials are showing signs of life after having been dead for so long, and commodities are breaking out. Even energy stocks, which are facing strong secular headwinds, are showing signs of life as the market begins to price in life after Coronavirus.
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Concentration risk is not as much of a concern as it would appear. Is it “different this time” in terms of the largest components of the market index? We are always loath to say that, given it is rarely “different this time.” The largest components of the S&P index are robust tech stocks which, when compared with the index titans of the past, seemingly have 1) larger moats, 2) less cyclicality, 3) greater secular tailwinds, 4) and strong balance sheets with less need for additional capital. Additionally, the valuation ratios of these companies are less of a concern because the earnings being used to calculate the valuations are restrained because the companies have higher earnings flexibility. In other words, because they can generate higher earnings at any moment by pulling back on reinvestment within the company, investors reward the companies with reasonable PEs on the normalized earnings, which come off as excess PEs on earnings considered to be understated by the market.
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Liquidity is likely to be the dominant factor. What about the increased liquidity from the Federal Reserve? Liquidity injections are nothing new. But as we said when the Fed first issued its liquidity at the onset of the pandemic, their moves were very decisive. The agency used virtually all its policy weapons to stimulate demand, buy time and limit economic fallout. In short, they bypassed the bazooka in favor of a Howitzer.
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Excess Fed liquidity over the recent decades has typically found its way into the asset market rather than into the hands of those most impacted by the economic damage. This is because generally these injections serve to shore up the banking system and keep investor confidence higher. The Fed generally relies on Congress to effect fiscal stimulus in order to get money directly into the hands of consumers, as the Fed is impotent to do such. The result of this cannot be overstated as we saw how quickly markets rebounded after bottoming in March, while many small businesses at ground zero of the economy (e.g., restaurants, hotels) continued to struggle.
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Thinking Differently About Income: Focus Foremost On Total Return Investors and business owners continue to struggle with generating income in this low-interest environment. Traditional savings products no longer generate desired income, with yields on most fixed income products below inflation. This is clear from questions we continue to receive from businesses owners who are considering selling their businesses or have sold. In advance of a sale, they ask questions such as, “What do I need to sell my company for before taxes to generate sustainable cash flow?” After the sale, the questions mirror this concern: “Now that I have sold my business, will I be able to generate enough income to replace the cash flow I had from my company?” Given these top-of-mind concerns, many incomeseeking investors desire a portfolio that is focused more on yield than on capital appreciation. Much of the focus on yield enhancement stems from a common misconception that higher yields offer downside protection to a portfolio via the income offsetting the impact of a falling stock price on the portfolio. But this is not the case. The regular income generated by a high-yielding portfolio is not a “free lunch,” so to speak. When the company pays out cash, the market value of the capital base falls by a commensurate amount.
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In addition to the perceived shock absorber effects of yield, some investors desire yield for the stability provided by the “certainty” of income. However, while such a yield level was riskless years ago, it is no longer available in an environment with a 10-year Treasury rate of 1%. Even worse than the nominal yield, real yields (i.e., nominal yields less inflation) have compressed to 0% and, in some cases, have gone negative. In today’s world, because this income availability is relatively non-existent, investors have two options: 1) invest in higher-yielding assets to obtain the level of absolute yield required to meet desired (or, in the case of foundations, regulatorily required) spending needs, or 2) supplement yield with capital appreciation. The former option leads to investors taking on more risk than desired, which often contrasts with other portfolio goals. The latter allows client to create their own streams of income while regularly rebalancing their portfolios. Of course, if the low interest rate dynamic reverses as interest rates move higher, then investors can tilt portfolios back toward more yield and reduce the emphasis on capital appreciation.
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Unfortunately, investors desperate for yield often unwittingly compromise on their risk tolerance or needed liquidity in the quest to earn more income. Focusing on the portfolio’s total return offers a better path. Recall that total return is the overall gain on an investment over a specified time period, contemplating both: 1) gains on the capital deployed throughout the holding period (i.e., price appreciation), and 2) income on that capital (typically in the form of dividends and interest). For investors who choose to reinvest their income distributions as capital back into the investment, the return will contemplate gains and income on that reinvested capital as well, compounded over the investment period. Unfortunately, investors desperate for yield often unwittingly forgo stronger overall total return in order to get more yield. This is because companies not focused on generating yield are generally companies with more growth opportunities and, thus, choose to allocate their earnings toward reinvestment in higher-returning projects rather than paying it out to shareholders as dividends.
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Think of it this way: if a company’s management team has a choice to either pay out earnings or to invest earnings in a project that will return 10% annually over five years, the latter will generate more returns for the company and will serve to boost the company’s stock price higher. In such a case, the return generated by the stock would have less yield but likely higher total return. Think of taking a total-returns approach as targeting an annual return irrespective of whether that comes from income or across from all sources (interest, dividends and growth). In any given year, this may or may not involve tapping the original capital; of course, in a low interest rate environment, this is likely to be the case.
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We continue to believe in two vitally important benefits to using a total return approach: 1. Yield-focused portfolios constrict the
universe of possible investments for the portfolio because many investments do not specifically target income generation.
Focusing on total return allows for the portfolio to be allocated across a broader swath of securities, some of which may also serve to reduce overall portfolio risk as many higher-yielding securities are concentrated in relatively few sectors (e.g., Energy, Consumer Staples), and loading up on these positions may introduce a lack of diversification.
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2. This approach has the potential to offer
superior tax efficiency and thus generate even better post-tax returns.
For example, investors can hold higher-yielding investments in tax-deferred accounts and assets aimed at capital appreciation in taxable accounts.
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Aside from those two considerations, there is another large factor that tilts the scales toward the total returns approach, where raising cash to meet spending needs could be accomplished, quite simply, by selling part of the portfolio. Such an approach would also allow investors to idiosyncratically time their sales to accommodate their cash flow needs rather than relying on a predetermined schedule as determined by the investment. By raising funds on demand, these sales can be timed with cash flow needs and/or when the investor finds the market conditions most appealing.
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In summary, focusing too specifically on income generation may restrict portfolio return, potentially reduce diversification, and lower the opportunity for tax alpha opportunities. Investors should focus on total returns, not income, and fund their spending by selling part of their portfolios to align strategically with cash flow needs and market conditions.
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What’s ahead for 2021 While all our recommendations to clients have always been centered foremost on their overarching goals, we increasingly believe that investors get the best results over time when we focus foremost on outcome and goals rather than relative returns and benchmarks. While the latter two certainly matter, they are tactical means to an end. The former takes a much more strategic view of client portfolios. As we come out of the turbulence of 2020 and into the unknown of 2021, this approach is more important than ever.
unnecessary risk. In short, we believe the most important question to ask now is not “How did I do against the benchmark?” but, rather, “Am I still able to achieve the investment goals I set out for myself?” or “Will I have enough liquidity for both expected and unexpected needs?” Clients can expect to see our teams take our current investment chassis (namely, the Balentine building blocks noted on page 1) and continue to refine that with fine-tuned recommendations around private capital and strategic global allocations.
Balentine’s approach to goals-based investing is to avoid being unduly governed by benchmarking and to instead anchor on higher-order aspirations of income potential, liquidity and avoidance of
In 2021 we expect to focus on three primary strategies which address the continuum of goals-based investing for our clients.
Fuel growth (“Appreciation”)
Tilted toward stocks and away from bonds
Supply spending needs (“Growth and Income”)
Protect assets (“Capital Preservation”)
Balanced across stocks and bonds
Tilted toward bonds and away from stocks
< AGGRESSIVE
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CONSERVATIVE >
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Private capital: necessary fuel for portfolio performance going forward At Balentine, we have long been advocates of private capital as a useful instrument, always bearing in mind the inherent tradeoff it creates between potential return/upside and liquidity. In return for having limited access to a portion of capital for anywhere from roughly 1â&#x20AC;&#x201C;15 years, clients can achieve a meaningful return spread over the public markets.
Private capital has always been an important part of our investment toolkit for clients and will be even more important in 2021. Each of our goals-based strategies will recommend a private capital component that will be tuned relative to each clientâ&#x20AC;&#x2122;s individual liquidity needs and risk tolerance. We believe a material allocation to private capital is going to be necessary for the next cycle as the market digests a permanent player in the bond market in the form of the Fed and a winner-take-all effect in the equity market.
Due to the illiquidity factor of investing in private markets, there is a risk premium that we think should accrue over time to investors, a spread we believe is important as we enter 2021.
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Public equities: feast or famine The reasons for this belief are the structure of the public equity markets and starting yields in the public debt space. The public markets are becoming a feast-or-famine, winner-take-all battle royal where the few top performers capture a large share of the rewards and the others capture crumbs. Additionally, companies don’t stay on top forever. Passive investors in the S&P 500 will have 23% of their investment in five companies, and the other 77% in 495 companies. Apple, Microsoft, Amazon, Google and Facebook have run laps around the rest of the market and deserve their place at the top. But a quick look back at 1980 will show the top five companies then were IBM, AT&T, Exxon, Standard Oil of Indiana and Schlumberger. That’s a complete turnover in the top performers. While Apple, Microsoft, Amazon, Google and Facebook are currently feasting, there are other parts of the market experiencing famine. An investor who wanted to own something besides mega cap names could buy a basket of small stocks in the Russell 2000. Once the minor leagues for large cap companies (in fact, once home to Apple, Microsoft and Amazon), the cost of going public has forced many companies in this group to stay private for longer. This has caused the Russell 2000 to be
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populated by struggling companies that cannot graduate to the big leagues or companies that cannot find capital elsewhere. To this point, 48% of all companies in the Russell 2000 do not show a profit, a percentage nearly double that of its long-run average (26%). Meanwhile, private companies continue to grow and then go public as large-cap names. For example: Peloton went public with an $8.2 billion valuation Zoom went public with a $9.2 billion valuation Facebook went public with a $104 billion valuation By comparison, Amazon was valued at $438 million ($710 million inflation-adjusted in today’s dollars). While Peloton, Zoom and Facebook may all be great companies, the amount of return that can accrue to public investors is nowhere near the 120,000% an Amazon IPO holder has experienced.
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Fed intervention and the long-term squeeze on rate-dependent investors A different phenomenon is occurring in the public debt space: the persistent intervention of the Federal Reserve. The Federal Reserve’s balance sheet has consistently grown since the 2008 crisis. There was a short period where it began to shrink and the market reacted to rates it saw as rising too quickly,
which led in part led to the turbulent fourth quarter of 2018. Essentially the Fed threatened to take away the candy, and then quickly changed course again as the market stomped its foot and screamed, announcing around Christmas that it would not raise rates (in order to satisfy the markets and quell the tantrum—an act any parent can relate to in desperate times).
Recession 2007–2009
Coronavirus Recession
$7T $6T $5T $4T $3T $2T $1T August 2007– Present Source: Federal Reserve Board of Govenors via FRED, July 2020 This illustrates the Fed’s balance sheet since the 2008 crisis and just how active they have been in buying bonds.
1
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The knock-on, secondary effect of their buying and intervention is interest rates below 1%, putting a squeeze on conservative investors who have depended on bonds to provide a ballast in their portfolios and income for spending. With a Fed that is supposed to be fully independent but which has shown repeatedly it will be there as a backstop to the market (with an accommodative policy of artificially low rates), it is hard to see this trend changing. In the case that it does, and rates revert higher, those bond holders are going to take a hit on their capital as bonds lose value as interest rates rise. Thus, the combination of the winner-take-all in equity markets and meager returns in the bond markets leads us to believe the typical 60/40 stock/bond portfolio will experience lower returns and higher risks over the coming cycle. While this will be partially alleviated by our tactical rebalancing through Tier I and Tier II, this is also why we believe investors should be willing to accept some degree of illiquidity in 2021 and beyond and put money to work in the private markets.
OTHER BENEFITS OF PRIVATE CAPITAL In addition to the illiquidity premium that generally accrues to investors in private vehicles, private capital can offer several other benefits within a broader portfolio:
Access to the full life cycles of companies. Allows investors to capture value at all phases, from burgeoning idea (venture capital), to high growth times (growth equity), to mature expansion (leveraged buyout).
Increased yields. Private debt managers can buck the low interest rate regime by lending to middle market companies, which has historically generated more favorable interest rates owing to a higher corporate demand for loans relative to the supply available.
Ownership of real assets with inflation linked cash flows. Private real estate and infrastructure offers direct ownership of hard assets that power our economy and can provide a buffer in the case the long-elusive inflation returns.
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HELPING INVESTORS BALANCE OPPORTUNITY AND RISK IN THE PRIVATE MARKETS While we are suggesting that many investors embrace the illiquidity factor in order to access equity, credit and real assets in the private markets, the amount and nature of any illiquid investments in a portfolio should remain a function of the investorâ&#x20AC;&#x2122;s goals (i.e., what return do I need?) and spending needs (i.e., do I have enough liquid investment to fund my spending?) We understand there are some hurdles to private investing. Many investors are concerned that they will need money over the typical 10-year duration of those investments. Investors may also be concerned that so much money has already gone into private markets. While these are legitimate concerns, they can be overcome. As it pertains to liquidity, our team conducts extensive worst-case-scenario and spending needs analyses to inform any recommendations we may make. We set guard rails for each client and take every possible measure to ensure clients can support spending needs in the case of adverse market outcomes. It is also important to note that just because a $1 million commitment is made to a 10-year fund, that this does not mean an investor has no access to that $1 million for 10 years. History shows that a $1 million commitment will typically call $200,000 a year for four years before it starts paying money back to the investor. Rarely does an investor pay in the full $1 million, and seldom ever for the full 10 years. There has also been a lot of talk of record levels of dry powder, which is money still to be deployed in the private capital space. While this is true, as dry powder in private equity approaches $1 trillion, it has grown in line with the public markets. On the next page we show a chart that depicts the market cap of the S&P 500 versus the dry powder in private equity.
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S&P Market Cap
Dry Powder
1/2020
1/2019
1/2018
1/2017
1/2016
1/2015
1/2014
1/2013
1/2012
1/2011
0% 1/2010
$ 1/2009
5%
1/2008
$5T
1/2007
10%
1/2006
$10T
1/2005
15%
1/2004
$15T
1/2003
20%
1/2002
$20T
1/2001
25%
1/2000
$25T
Ratio
Sources: Preqin, Factset, Balentine
This data combined with our experience gives us assurance that excesses in the private space are not rampant. Another line of defense and the key to the quality of investments we recommend is a robust due diligence process. We partner with only proven, experienced global and local managers, some of whose firms go back many decades and whose experts have successfully navigated multiple market disruptions and the GFC. In most cases we are allocating to funds that are on their fourth fund or beyond, a clear demonstration of their performance track record and administrative excellence.
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While we understand the thought of 10-year lock ups, K-1s and capital calls can be daunting on their face, we remain confident in our highly discerning due diligence process. We firmly believe it is possible to choose private investments in a way that allows investors to take advantage of their topside potential while also managing risk strategically and effectively.
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In Closing We hope you find this yearâ&#x20AC;&#x2122;s Capital Markets Forecast informative in understanding what is realistic to expect in the months ahead from todayâ&#x20AC;&#x2122;s starting point and what possibilities exist to achieve portfolio goals.
Such a portfolio is comprised of:
In summary, in an environment with low interest rates and potential growth challenges, what levers does your portfolio use to replace or supplement the income you need to live? Aside from increasing the percentage of higher risk assets (which, all else equal, we do not recommend) and/or reducing spending, the key is to build a better portfolio.
d) tactically rebalancing, when appropriate
a) some lower yielding, fixed income securities b) an increased focus on capital appreciation c) taking on some illiquidity
Balancing risk, illiquidity, and total return, as exemplified in the chart below, allows us to customize portfolios for clients to best balance these three levers.
6% 5% -10%
4% 3%
-15%
2% -20%
Max Expected Drawdown
Total Return Breakdown
-5%
1% -25% 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 21% 22% 23% 24% 25% 26% 27% 28% 29% 30%
0%
Capital Gains Source: Factset and Balentine
Income
Max Drawdown
Percentage of Portfolio in Illiquid Assets
If you would like to discuss any aspect of this Forecast and its implications within your own portfolio, please reach out to a relationship manager or any member of the Investment Strategy Team. We appreciate this opportunity to share our outlook with you and look forward to helping you navigate the year ahead with clarity and confidence.
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Appendix Each year, we update our forecast of capital market returns for the next market cycle—as measured by the succeeding seven-year period—because future market returns are a function of the starting point, specifically, projected income and projected adjustments to valuation. As a result, the goal for our strategic forecast is to update our outlook to account for year-over-year changes to the starting point of the new seven-year cycle. We update our strategic forecast for asset classes on an annual basis, but that does not mean these are tactical, one-year allocations. Instead, our updated returns contemplate the market’s actions during the preceding year and rely on mean reversion. Over the long term, markets show a strong tendency to mean revert to historical averages adjusted for underlying trends. This happens because high profits and momentum attract investors and drive down future returns in highly-valued asset classes. Our update includes answers to the following questions:
What public market returns are realistic during the market cycle? What risks may have to be assumed to capture those returns? What opportunities do investments in private markets have to offer? Based on our updated projections, we restructure our strategic asset allocation targets in key areas to maximize the efficiency of our strategies and, therefore, better meet our clients’ objectives over the next market cycle. Our forecast provides the quantitative blueprint for the steps we are taking designed to both manage risk and maximize opportunities in 2021 and beyond.
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Fixed Income YTM
Duration
Bloomberg Barclays U.S. Aggregate
1.2%
6.2
Bloomberg Barclays U.S. Treasury
0.6%
7.2
Bloomberg Barclays U.S. (7Y–10Y)
0.8%
7.5
Bloomberg Barclays Municipal Bond
1.1%
5.1
Bloomberg Barclays U.S.Aggregate Credit - Corporate - Investment Grade
1.9%
8.8
Bloomberg Barclays U.S. Aggregate Credit - Corporate - High Yield
5.1%
3.6
Bloomberg Barclays U.S. Treasury Inflation Protected Notes (TIPS)
0.8%
3.8
Bloomberg Barclays Global Aggregate
0.9%
7.4
JP Morgan EMBI Global Diversified
4.6%
8.0
Return
Risk
MSCI All Country World (Global equities)
5.4%–7.9%
16.5%
Russell 1000 (U.S. Large Cap)
1.0%–3.2%
14.5%
Russell 2000 (U.S. Small Cap)
1.7%–4.0%
19.2%
MSCI EAFE (International Developed)
5.0%–8.0%
17.0%
MSCI EAFE Small Cap (International Developed Small Cap)
5.5%–8.5%
19.7%
MSCI Europe
4.7%–7.9%
17.0%
MSCI Japan
5.0%–9.4%
21.0%
MSCI Emerging Markets
8.5%–13.4%
23.5%
Return
Risk
2.7%–3.7%
5.2%
Return
Risk
10.4%–12.9%
9.5%
Market Risk
Alternatives HFRI Fund of Funds
Private Capital Cambridge PE Source: Balentine
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Disclosures The opinions expressed are those of Balentine. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Forward looking statements cannot be guaranteed. Balentine reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. It should not be assumed that any of the securities transactions, holdings or sectors discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein. Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed.
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The S&P 500® Index is the Standard & Poor’s Composite Index of 500 stocks and is a widely recognized, unmanaged index of common stock prices. The Russell 1000® Value Index measures the performance of the large cap value segment of the U.S. equity universe. It includes those Russell 1000 companies with lower price-to-book ratios and lower expected growth values. The Russell 2000® Growth Index measures the performance of the smallcap growth segment of the US equity universe. It includes those Russell 2000® companies with higher price-to-value ratios and higher forecasted growth values. The Dow Jones Industrial Average is a price-weighted average of 30 blue-chip stocks that are generally the leaders in their industry. It has been a widely followed indicator of the stock market since October 1, 1928.
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Balentine LLC (“Balentine”) is an independent investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about Balentine, including our investment strategies, fees, and objectives, is included in the Form ADV Part 2, which is available upon request. The opinions expressed herein are those of Balentine and are subject to change. Past performance is not indicative of future results. The information provided in this report should not be considered financial advice or a recommendation to buy, sell, or hold any particular security. It should not be assumed that any of sectors discussed were or will be profitable, or that the investment recommendations or Balentine
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makes in the future will be profitable. There is no assurance that any sectors or industries discussed herein will be included in or excluded from an account’s portfolio. Balentine reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. Recommendations made in the last 12 months are available upon request. Balentine is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about Balentine’s investment advisory services and fees can be found in its Form ADV Part 2, which is available upon request. Past performance is not indicative of future results.
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