by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Our Comment begins with a discussion about whether the Fed can deliver a soft landing, Russia’s decision to reverse course on oil exports, and why investors should pay attention to Mexican politics. As usual, our report also provides an overview of the latest domestic and international data releases.

Landing in Limbo: Investors are divided on whether the economy will achieve a soft or hard landing, but they agree that the labor market will be a key factor in determining the outcome.

• A week after the Federal Open Market Committee (FOMC) released its economic projections which showed upward revisions to GDP and interest rates, investors have expressed skepticism about the FOMC’s optimistic outlook. The FOMC’s forecast contrasts starkly with CEO and consumer predictions of an 84% and 69% chance of a U.S. recession in 2024, respectively. The uncertainty has rattled financial markets, with the S&P 500 falling nearly 5.0% since September 1, as investors lock in gains and position themselves for a possible correction. This cautiousness may persist until investors see clearer signs of the U.S. economy’s direction.
• The labor market is the biggest source of contention, as it has remained stable despite other signs of economic weakness. Employment levels are high, and initial claims and unemployment have remained near historic lows, even as the Federal Reserve has raised interest rates to their highest level since 2007. This strong labor market has fed optimism that a recession is unlikely in the near term. However, below-trend growth in labor force participation from workers over the age of 55 has led to concerns that the data is still being impacted by pandemic distortions.

• Recessions are notoriously difficult to predict because economic conditions can change rapidly and without warning. This uncertainty explains why investors have cooled on government bonds, as mixed data has complicated efforts to price in risk. Next year will be another test of forecasters’ accuracy, as many still believe the country will enter a recession in the first half of 2024. That said, despite evidence of decelerating economic activity, especially in consumer spending, we remain optimistic that the expansion still has a lot of gas left in the tank.

Trouble in Moscow? Russia has begun to ease some of its oil export restrictions in a sign that the government is seeking to increase its revenue.

• The Kremlin announced that domestic producers would resume seaborne exports of diesel on Thursday, reversing a three-week ban imposed due to domestic supply concerns. The decision was likely an attempt to prevent rising fuel prices from becoming a political liability ahead of the March 2024 elections. The U-turn comes days after a report showed that Saudi Arabia and Russia, the leaders of the OPEC+ oil production cuts, increased crude exports last month, allowing Moscow to inflate its profit margins at a time when it is seeking to increase its military spending in Ukraine.
• The increased availability of Russian oil should help relieve some of the tightness in the crude market. Over the past few months, fuel prices have risen as refiners struggled to make up for the shortfall created by Russia and Saudi Arabia’s decision to cut crude production. This has led to a strain in crude inventories in many countries, including the United States. In August, global commercial inventories declined by 60 million barrels, with the U.S. seeing a drawdown in Cushing for 12 out of the previous 13 weeks. Diesel prices in Europe fell 3.0% after reports of Russia’s policy shift.

• That said, a potential economic slowdown may have bolstered Russia’s decision to reverse course. Oil prices were approaching $100 a barrel a few weeks ago, but anxiety about future demand due to growth concerns has caused prices to fall. This week, Brent prices fell below $85 a barrel, erasing the gains made in September. The price slump will likely hurt Russian efforts to increase the budget by 26% in its next fiscal year. Last month, it was able to run a surplus in oil sales, but it is unclear whether this will persist if prices continue to fall.

AMLO Is Not Your Friend: With a little over a year left in his presidency, President Andrés Manuel López Obrador (AMLO) continues to rattle investors.

• Mexican President AMLO surprised investors with an unexpected change to airport concession agreements. The new arrangement changes the tariff system which affects passenger fees, airport services for the use of runways, and leasing spaces to airlines and suppliers. The move appears to be driven by AMLO’s long-running feud with the airline industry and his desire to nationalize the sector. In 2018, AMLO canceled the construction of a new airport, only to reopen an alternative hub in a former military air base three years later. Earlier this year, he announced the revival of the state-run airline Mexicana de Aviación and transferred the operations of Benito Juarez International Airport to the Navy.
• Mexican assets tumbled after the surprise change to airport concession agreements, as investors were shocked by the government’s decision to challenge previous agreements and feared that other industries could be next. The country’s benchmark stock index fell 4.4% on Thursday, and the Mexican peso (MXN), one of the world’s best-performing currencies, fell 1.7% against the dollar. The sell-off reflects uncertainty about AMLO’s next moves before he leaves office. Last month, the president spooked markets by submitting a budget proposal that would triple the current year’s outlays to their largest level since 1988. As a result, investors offloaded bonds across the various maturities, fearing that AMLO was no longer committed to fiscal conservatism.

• Mexico’s situation illustrates the political risks associated with reshoring manufacturing. AMLO’s efforts to rein in wasteful spending and inefficiencies were widely viewed as positive by investors, and his reputation as a fiscal hawk has contributed to investor optimism that the business environment may improve once he leaves office. However, recent initiatives and AMLO’s political influence suggest that his draconian measures may have been a ruse to usher in a new era of Cardenismo (Mexican nationalist populism), rather than any desire to promote government soundness. Investors should, therefore, pay close attention to Mexico’s elections next year, as AMLO’s successor will likely be pressured to continue his policies.

Ins and Outs: The U.S. shot down a Turkish drone in Syria after military officials believed it posed a threat to American forces. While it is unclear whether this will rupture U.S.-Turkey relations, it does highlight the two countries’ disagreement over Syrian Kurds, whom Ankara views as a threat. President Trump’s influence in Congress is growing after he endorsed Jim Jordan (R-OH) to take over as House Speaker. Jordan’s selection could raise the likelihood of a government shutdown in November. Workers at an LNG plant in Australia will resume their strike, which poses a threat to energy markets, particularly in Europe where Australia is the third largest supplier.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Happy Fat Bear Week! We’ve already filled out a bracket, and our money is on #32 Chunk to take the crown as the fattest bear. Today’s Comment discusses the recent rise in global bond yields, the ongoing dollar drought, and problems with funding for Ukraine. As usual, our report also provides an overview of the latest domestic and international data releases.

Bond Bears Roar: Yields are increasing due to uncertainty over the future of monetary and fiscal policy, but this is likely to be temporary.

• Partisan governments and soaring inflation in advanced economies are making it difficult for investors to price future risks as governments struggle to find a clear path back to normalcy. This is particularly evident in Europe, where governments are built on fragile coalitions and Spain has been unable to form a government, and in the United States, where the House of Representatives ousted Speaker Kevin McCarthy (R-CA). Meanwhile, a slowdown in global economic activity and elevated inflation have complicated the central bankers’ ability to conduct monetary policy as policymakers struggle to reach a consensus on a path forward.
• Missed economic growth forecasts and unclear plans for addressing pandemic deficits have weighed heavily on investor sentiment. At the start of the year, many expected the U.S. and Europe to enter recessions in 2023, but the labor market has remained resilient in both regions. This has led the central bankers and investors to push up their expectations for policy rates as they look to keep inflation from becoming sticky. On the fiscal side, the EU has struggled to get governments, such as Italy and France, to comply with deficit targets that will come into effect in 2024. At the same time, U.S. budget projections show that the deficit is expected to exceed GDP over the next few years unless lawmakers decide to cut spending or raise taxes.

• Interest rates are unlikely to return to pandemic levels anytime soon, but yield pressures could ease in the coming weeks. Weaker economic data could reduce inflation expectations and prompt policymakers to pivot, leading to a decline in the yields of 10-year German Bunds and U.S. Treasuries. This expectation was evident in the recent decline in global bond yields following disappointing euro area retail sales and ADP private payrolls data. However, concerns over widening deficits and volatile inflation may temper any drop in yields, as lawmakers struggle to address budget shortfalls without political blowback.

When The Fed Sneezes: A shortage of U.S. dollars is cascading through emerging markets, causing widespread disruptions.

• Countries in Africa, Asia, and South America are reeling due to the lack of dollar liquidity. The shortage of available greenbacks has made it difficult for countries to pay for imports and repay debts, leading to a series of economic and political shocks throughout the developing world. The Pakistani government has imposed capital controls that restrict profit repatriation. Nigeria’s currency has plummeted against the dollar. At the same time, political instability in Bolivia has deepened amid soaring inflation and economic hardship. It is estimated that poorer countries owe around $200 million to their wealthier counterparts.
• The U.S. dollar shortage is a direct result of the Federal Reserve’s quantitative tightening policy. Last month, the central bank’s balance sheet fell under $8 trillion for the first time since June 2021. This drawdown has been particularly difficult for commodity-dependent countries, which have struggled to export their goods due to the recent global economic slowdown. As a result, governments have been forced to reduce spending and have asked creditors to restructure their debt payments. This has left some countries with reduced credit ratings and higher interest rates to compensate for the new risk. A JPMorgan index showed that 16 countries, or 23% of the index, had yields 10% or higher than those of the United States and Germany.

(Source: Federal Reserve Bank of Saint Louis)

• The situation in emerging markets may worsen but should not spillover to the U.S. Only 11 countries have defaulted in the past few years, far lower than the 1980’s peak of 58. Additionally, the debt issues are less of a problem for larger developing nations such as Brazil and India. However, that does not mean there will be no negative effects for certain sectors of the American economy. An increase in defaults could make it difficult for grain and commodity exporters to sell goods to affected nations, which could lead to increased hunger and social unrest.

Putin’s Waiting Game: The Russian president has been biding his time in hopes that the West will drop its support for Ukraine.

• Funding the war in Ukraine is causing frictions throughout the West, especially as governments struggle with widening budget deficits. In the U.S., a dispute over new funding for the war has contributed to a standoff in budget negotiations. Meanwhile, in Europe, sympathy for Russia is rising, particularly in Eastern European countries such as Slovakia, Bulgaria, and Hungary. This new resistance comes at a time when Ukraine’s much anticipated counteroffensive has finally shown signs of life following weeks of making only slight progress. The dispute over funds highlights the growing fatigue of the fight.
• The main contention of the war is its economic fallout, both in terms of its cost and its impact on trade. American lawmakers argue that spending on the war is complicating efforts to reduce the budget deficit. Eastern European countries complain that preferential treatment to Ukrainian exports has come at the expense of their own agricultural industries. Rising dissatisfaction with the war is impacting elections, with more voters selecting candidates who favor a shift away from Kyiv. This situation could worsen if gasoline prices remain high in the coming months. That said, Moscow is also facing funding issues.

• The longer the war rages on, the greater the risk of Ukraine losing support. While the West insists that peace can only come with a Russian withdrawal, markets care little about the actual outcome of the war, just that it ends. Any resolution that leads to an end to the conflict should calm investors’ concerns about commodity volatility and pave the way for the West to relax increasingly ineffective sanctions. European equities could be one of the biggest beneficiaries of this outcome, as they may be able to regain access to Russian energy. However, the path of normalization of ties between Brussels and Moscow remains uncertain.

Ins and Outs: Accusations of industrial espionage by Chinese tech giant Alibaba (BABA, $83.17) are likely to worsen the growing distrust between the West and China. Saudi Arabia’s exploration of a theme park is further evidence that the country is seeking to diversify its portfolio as the world transitions to a more sustainable economy. The Biden administration’s reversal of the border wall construction highlights its growing concern over the rise in illegal immigration. Rising yields and declining imports add to concerns that the Fed may not be able to avoid a hard landing.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with U.S. news, with a focus on last night’s historic vote in Congress to remove House Speaker McCarthy.  We next review a wide range of other international developments with the potential to affect the financial markets today, including a bond market intervention by the Bank of Japan and big, new military spending plans by Russia.

U.S. Politics:  In a historic vote last night, the House of Representatives voted to end Republican Kevin McCarthy’s tenure as Speaker, leaving the chamber in chaos.  As is tradition, all 208 voting Democrats cast their ballot to remove McCarthy, but they were also joined by eight far-right Republican rebels who have criticized McCarthy for being insufficiently committed to sharp cuts in federal spending and other conservative causes.  The votes against McCarthy totaled 216, just enough to beat the 210 Republicans who voted to keep him in his position.

• McCarthy quickly announced that he will not try to reclaim his post, and House Republicans said they would leave Washington and return next week to vote on a new Speaker. That leaves the chamber without a leader for the time being.
• McCarthy had earlier named North Carolina Rep. Patrick McHenry as the pro tempore Speaker, but McHenry will not have the full powers of the office.
• The result will likely be another messy Republican battle for the Speakership. Currently, the front-runners are probably McHenry, along with the Republicans’ #2 and #3 leaders in the chamber: Rep. Steve Scalise of Louisiana and Rep. Tom Emmer of Minnesota.  It isn’t clear whom the hard-right Republican rebels would support.
• Press reports indicate the Democrats’ decision not to save McCarthy stemmed largely from anger over his efforts to placate the hard-right members of his caucus. Going forward, key questions include whether the Republicans’ chaos will discredit their party and boost the Democrats politically.
• For the economy and financial markets, a central question is how the leadership vacuum will affect the negotiations over the federal budget for Fiscal Year 2024. The weekend’s stopgap spending bill has authorized federal outlays at FY 2023 levels only until the middle of November.  If the Republicans and Democrats can’t agree on appropriations after that, there would be renewed risk of a partial government shutdown.

U.S. Bond Market:  Investors continue to sell off fixed-income assets, pushing prices lower and boosting the yield on the benchmark 10-year Treasury note to a fresh 16-year high of 4.831%.  The two-year Treasury note has risen more tepidly to about 5.159%, narrowing the 10-2 yield inversion at just 32 basis points.  As we had long warned, investors are finally repricing bonds downward after realizing the obligations had been priced too richly in the face of persistent inflation pressures and the Fed’s intention to hold interest rates higher for longer.

• Separately, CBOE Global Markets (CBOE, $157.24) and S&P Dow Jones (SPGI, $356.42) said they will launch four new indexes aimed at tracking the volatility of U.S. and European corporate bonds. The indexes will launch next week.
• The companies hope the new indexes will match the success of the original VIX for stocks. Over time, options or other financial products tied to the new bond VIX indexes are likely to become available.

U.S. Housing Market:  With bond yields rising, investors probably expect the interest rate on residential mortgages to be rising in tandem.  In reality, mortgage rates have been rising even faster than the yield on the 10-year Treasury note, which is their typical benchmark.  The reason is that even as Treasury yields have been rising, the Federal Reserve and commercial banks have been actively unloading their holdings of the mortgage-backed securities, driving up MBS yields.  Since MBS issuance funds so much of the nation’s mortgages, the result is that residential mortgage rates could well be on their way to 8% or more.

Global Airline Industry:  Reports say airlines around the world are dealing with a potentially costly scandal in which they inadvertently bought engine replacement parts with falsified safety certificates from what appears to be a phantom company in the U.K.  The airlines are now scrambling to identify and replace any uncertified parts that have been installed on their aircraft.  The questionable parts have been found on approximately 100 planes so far, forcing the airlines to take them out of service, pull their engines, and replace the parts.

Japanese Bond Market:  As Japanese bond yields rise along with the upward trend in U.S. yields, today the Bank of Japan offered to buy an extraordinary 1.9 trillion JPY ($12.7 billion) of Japanese government bonds with maturities ranging up to 10 years.  The unexpectedly large purchases appeared to be tied to the BOJ’s controversial yield curve control policy, in which it is keeping short-term interest rates negative while capping the yield on the 10-year JGB at 1%.

• Despite the intervention, however, the yield on the 10-year JGB rose to 0.783%, as investors increasingly bet that the central bank will soon have to abandon its YCC policy.
• Meanwhile, the yen today strengthened by 1.8% to 147.3 JPY per dollar ($0.0068), compared with yesterday’s value of 150 JPY per dollar ($0.0067).

Japanese Industrial Policy:  As Tokyo continues working to secure a domestic supply of advanced semiconductors in the face of China’s growing geopolitical threat, the Industry Ministry yesterday announced it will provide up to 192 billion JPY ($1.3 billion) in additional subsidies for U.S. semiconductor manufacturer Micron Technology (MU, $67.83) for its new memory-chip factory in Hiroshima Prefecture.  That comes on top of the 46.5 billion JPY ($310 million) in aid to Micron that the government announced previously.  Tokyo also continues to provide enormous subsidies to build up a domestic supply of advanced logic chips.

European Union:  The Financial Times carries an interesting report today saying that some home buyers who used to flock to places like Portugal, Spain, or the South of France for the warm, sunny weather are now eying properties in northern regions seen as less susceptible to global warming.  After a summer of unusually hot weather and wildfires in southern Europe, northern regions like Brittany in France offer not only cooler weather but also much cheaper prices—for now.  The article is a reminder that even if you’re skeptical about climate change, the markets you participate in could be affected by others who are trying to respond to it.

United Kingdom:  In a speech at the Conservative Party’s annual conference, Prime Minister Sunak offered several red-meat policy changes for the right wing, including cancellation of an expensive rail line extension to the northern city of Manchester, tighter standards for secondary education, and tougher restrictions on youth smoking.  The proposals come just weeks after Sunak got a bump in the opinion polls from easing Britain’s climate-stabilization policies.  Nevertheless, Sunak and the Conservatives continue to trail the support for Keir Starmer and his Labor Party.

Russia:  The government’s draft budget for 2024 indicates the military will get 29.4% of all spending, equal to about $109 billion.  That’s more than double the 14.4% of the budget that the military got in 2021, before the Kremlin launched its invasion of Ukraine.  In RUB terms, the proposed military spending in 2024 would be about three times greater than in 2021.

• Since Russia has a long history of hiding some military spending in ostensibly civilian budget accounts and off-budget, it is likely that the country’s true military spending is even greater than indicated.
• As such, Russia’s defense burden is now clearly a strain on Russian state finances. To fund the enormous new military outlays associated with the war in Ukraine, Russian officials have said they will freeze spending on healthcare and education, while cutting spending on infrastructure and other economic development projects.  They have also indicated they will have to increase borrowing.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with a discussion of the battle brewing over Chinese influence at the International Monetary Fund.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a further worsening of Indian-Canadian relations and dramatic moves in cryptocurrency prices yesterday related to new exchange-traded funds for the assets.

International Monetary Fund-China:  IMF President Kristalina Georgieva has backed institutional reforms that would eventually give China greater voting power, according to an interview in the Financial Times.  In the interview, Georgieva argued that the IMF needs more funding to help struggling countries around the world, and that China should have more voting power based on the fact that it now accounts for almost one-fifth of the world’s economy but only 6% of the fund’s capital.

• Nevertheless, U.S. officials have signaled that they want to increase Western control over the IMF, so they would veto an increase in China’s capital.
• Capital adjustments at the IMF require the approval of countries that hold at least 85% of the institution’s capital. The U.S. holds 17% of the capital, the largest shareholder, so it could unilaterally veto any effort to increase China’s position in the fund.

China-Peru-United States:  Despite the U.S.’s ability to block increased Chinese diplomatic influence at the IMF, it is still struggling to counter China’s growing economic influence in less developed countries.  According to new reports, the U.S. has privately warned Peru that Chinese interests are gaining too much control over that country’s key infrastructure, including the electric utility serving the capital city of Lima and a new deep-water port on the country’s Pacific coast.  Control of those assets by Chinese state-owned or state-influenced companies could give Beijing leverage over Peru as it seeks to gain better access to key resources and undermine the U.S.’s geopolitical and economic positions.

India-Canada:  New Delhi has ordered Canada to withdraw about 40 of its diplomats based in India, ostensibly to equalize the number of diplomats each country has in the other.  However, the move is widely seen as further retaliation for Ottawa’s accusation that Indian agents killed a Sikh separatist and Canadian citizen in British Columbia last June.  The Indian government has also imposed a ban on new visas for Canadians wishing to visit India.

• The worsening bilateral tensions have weakened Canadian Prime Minister Trudeau’s domestic political position, especially as some have accused him of pandering to Canada’s sizable Sikh community.
• The tensions could also complicate the West’s efforts to enlist Indian support to counter China’s growing geopolitical power and aggressiveness.
  • Despite that concern, authorities in New Delhi this morning raided the homes of journalists, contributors, and staff of the website NewsClick, alleging that the news outlet is a Chinese propaganda organ.
  • The move follows several other measures that New Delhi has taken against Chinese influence in India as relations worsened in recent years.

European Union:  Average home prices rose by a seasonally adjusted 0.3% in the second quarter, partially reversing the declines in each of the previous two periods.  Nevertheless, second-quarter home prices in the broader EU were down 1.1% from the same period one year earlier, and prices in the eurozone were down 1.7%.  That marks the first annual home-price declines in Europe since 2014.

• The fall in home values largely reflects the European Central Bank’s long campaign of interest-rate hikes to combat high consumer price inflation, but it also shows economic headwinds for particular regions and sectors, such as German manufacturing.
• German home prices had the worst annual declines, down 9.9%, while prices in Denmark were down 7.6%, and prices in Sweden were down 6.8%.
• In contrast, prices were up 13.7% in Croatia and 10.7% in Bulgaria.

Argentina:  In an effort to derail the presidential ambitions of radical libertarian Javier Milei, who is currently first in the opinion polls ahead of the October 22 election, Economy Minister Sergio Massa has pledged to form a unity government if he wins the balloting.  However, vowing to form a government that would include Milei’s libertarians and Patricia Bullrich’s traditional center-right parties may alienate Massa’s own left-wing populist Peronists.  As of now, Milei remains in the electoral driver’s seat, raising the chance that he will come to power and try to implement his agenda of steep government spending cuts, deregulation, and dollarization of the economy.

U.S. Politics:  Last night, Florida Republican Rep. Matt Goetz announced a motion to oust House Speaker McCarthy over his weekend deal with the Democrats for a short-term funding bill for the government.  The motion launches a process that will require a vote by Wednesday evening.  With the Republicans having only 221 seats, while the Democrats have 212, it would appear at first glance that only a few Republican rebels could leave McCarthy at peril, especially if all the Democrats voted against him, as they traditionally would.  In this case, however, the prospect of a hard-right Speaker could encourage the cooperation of at least some Democrats to save McCarthy’s skin, especially if they could wring concessions out of McCarthy to do so.

U.S. Cryptocurrency Markets:  Bitcoin, Ethereum, Litecoin, and other cryptocurrency prices jumped yesterday as Grayscale Investments filed paperwork to convert its $5-billion Bitcoin futures ETF to a fund that could invest in the spot cryptocurrency.  Also yesterday, the first seven exchange-traded funds for Ethereum futures were launched.  However, prices for the various cryptocurrencies gave up most or all of their gains by the end of the day as the new Ethereum futures ETF garnered little investor interest.  Market data suggest turnover for the new ETFs totaled only about $7 million.

• Tepid demand for the Ethereum futures ETFs may show that individual investors are less interested in cryptocurrencies than previously thought. However, some observers suggest that investors simply prefer funds that invest in spot cryptocurrencies.  Of course, today’s high interest rates on money market funds have probably also sapped demand for cryptocurrencies.
• The Securities and Exchange Commission has signaled it may approve spot Bitcoin and Ethereum ETFs in the coming months.

U.S. Commercial Real Estate Market:  New data suggests companies have had some success forcing their employees back into the office after the pandemic era’s work-from-home policies, but that has only been enough to push office occupancy up to about 50.4% of 2019 levels.  Moreover, occupancy is now highly skewed to Tuesday through Thursday, with offices only about 30% occupied on Mondays and Fridays.  Separate data shows the overall office vacancy rate in the third quarter rose to 19.2%, just short of the record rate of 19.2% in 1991.

U.S. Auto Strike:  As the United Auto Workers’ strike against the top U.S. automakers continues, new research shows how the economic cost is broadening out to suppliers, dealers, and to the workers themselves.  According to the Anderson Economic Group, suppliers to the manufacturers under strike lost $1.3 billion in the first two weeks of the strike, while the manufacturers themselves lost $1.1 billion and auto workers have lost $325 million.  In related news, Ford (F, $12.31) and General Motors (GM, $32.47) said they have laid off an additional 500 workers at plants not under strike but that were affected by the work stoppages, bringing the total of workers laid off as a consequence of the strike to about 6,000.

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