COVID-19: The long-term impact on growth, inflation and investment returns
The COVID-19 pandemic has brought a host of new pressures to bear on pretty much the entire investment universe. Constructing and adapting multi-asset strategies in this environment requires a deep understanding of how those pressures interact – and how they are likely to evolve.
In this article we outline our expectations for the macroeconomic backdrop, inflation, equities – including US and Eurozone markets – fixed income, including government bonds and credit, and currencies. We also share our current key convictions and what we believe are the future challenges facing multi-asset investors.
This market shock has come after a relatively benign decade for investors. It hasn’t all been plain sailing – there has been the European debt crisis to contend with, and isolated shocks, such as 2013’s ‘taper tantrum’ and 2018’s end-of-year sell-off.
But overall, since the 2008/2009 crisis, investors have enjoyed an 11-year bull market, albeit one propped up by low interest rates and vast amounts of liquidity.
The arrival of the coronavirus pandemic brought this run to an abrupt end, substituting it with an unprecedented wave of volatility. One measure we use to evaluate how market conditions might impact multi-asset strategies is our proprietary turbulence index. This tracks the evolution of parameters based on volatility and correlation, and at the end of 2019 stood at just 3.86. By 20 March, as panic gripped markets, it had soared to 149.33. To put this into perspective, in early 2009, when the global financial crisis was approaching its peak, the measure was at 82.06.[i]
Shock to the system
Perhaps more startling, however, is the timeline of this crisis. In the previous global financial crisis, it took some 18 months for markets to fall from peak to trough; in 2020, it took just 22 days.[ii] And markets have shown some resilience. By the end of the first quarter (Q1) this year, global shares in euro had collapsed by -19%[iii], but year to date, they are up +3.8%[iv] in line with government bonds (+4.1%)[v]. Many might argue the rebound has happened too quickly, and we believe this apparently supportive environment should not be taken for granted.
Our ability to cope with fresh outbreaks appears to be becoming less costly in terms of economic impact, and certainly central bank support has been significant, and welcome. But plenty of uncertainty lies ahead. The economic rebound depends on policy, labour market reaction and indebtedness – as well as the virus itself.
However, the news from first BioNTech and partner Pfizer and then Moderna – that they had developed the first effective coronavirus vaccines - certainly didn’t disappoint. This is clearly very positive news, but equally we believe a mass rollout will take longer than perhaps expected – we could potentially be looking at the second half of 2021.
But the question remains – what does the shock and the aftermath of COVID-19 mean for future asset class returns? Has the pandemic markedly altered our expectations for the worse? In short, we don’t believe there has been a radical shake-up, but when it comes to long-term return expectations, investors do need to form some new and specific assumptions. They also need to factor in several different parameters that are shaping how markets – and our overweight and underweight positions – could evolve.
There are many variables at play, with a genuine risk many of which could easily send markets back into a tailspin – and asset class correlation tends to increase during periods of volatility, adding to the instability. We look at the macroeconomic state of play and outline our medium-term expectations for core assets.
The macroeconomic backdrop
In its October update, the International Monetary Fund forecast that global GDP will contract by -4.4% this year, slightly less severe than its previous estimate of -4.9%. However, the fall in GDP is likely to be temporary, as the organisation expects that growth will rebound to 5.2% in 2021.[vi] For our part, we presently anticipate a slighter lower contraction of -4.2% in 2020 and a slightly more upbeat 5.4% growth in 2021.
The picture will be blurred by likely sharp swings in GDP growth beyond this first phase of contraction and rebound. Overall, we expect a quick initial recovery for the US and Eurozone but see this diminishing. Our expectation is that the US will only return to 2019 GDP levels around the end of 2021, with the Eurozone following a little later. It will be some while more before economies can reclaim the GDP levels that could have been in place had the pandemic not happened – consistent with a full recovery.
The US posted a record growth rebound in Q3, with real GDP rising at an annual rate of 33.1%, following its steepest ever collapse in the previous quarter.[vii] Yet, the level of activity is still just -2.9% on an annual basis, and unemployment remains a major challenge. With benefits being curtailed, the pace of the recovery looks set to slow into Q4 and beyond. Overall, we forecast a -4.2% contraction for 2020 and growth of 4.5% in 2021. Over the long term, the scarring effect of the crisis should weigh on potential growth which should decline to 1.5%.
In Europe, infections are once again on the rise, particularly in the UK, Spain and France. Governments are reintroducing restrictions, albeit less strict than before. As a result, downside activity risks are rising, not least with growth momentum slowing into the summer. Government and European Central Bank (ECB) support remains critical. In all, we have lowered our forecast for 2020 to -7.7% and expect a rebound in 2021 to +5.2%. The long-term impact of the crisis on growth through lower investment and higher saving rates should be significant, reducing potential growth to 0.5% in the region.
Five-year average annual forecasts
(Source: AXA IM: As at Q2 2020)
China’s latest data suggested a broadening recovery, driven both by internal and external growth revival. This is likely to embolden the central bank to further reduce policy stimulus. We continue to expect supportive fiscal policy, which on balance leads us to consider upside risks to our current forecasts of 2.3% growth for 2020 and 8% for 2021.
Of course, emerging markets have long borne the burden of rising coronavirus, which is also re-surfacing in areas where it had receded. Governments continue to ease restrictions. Third-quarter data will likely post a material rebound, but the outlook for the following three months – and potentially beyond - is more cautious, particularly where fiscal support has faded.
We also anticipate that inflation rates will end 2020 lower than pre-pandemic levels. Inflation should firm up in 2021 due to oil price base effects, but we forecast inflation below target for 2022. There has been concern that policy intervention during the pandemic could lead to an inflation surge, but it is not necessarily the case that money creation feeds through inflation.
Ultimately, an analysis of highly indebted governments increased fiscal spending and central bank balance sheet expansion, does not alter our opinion that inflation is likely to be subdued and below target for the next three years, an outlook exacerbated by the pandemic. However, we also consider longer-term changes that could take place beyond this framework. We believe that in the medium to long-run i.e. three years plus, institutional changes in key developed economies could complicate the evolution of inflation as could changes in investment, productivity and globalisation.
We do not want to argue that inflation will continue to drift lower indefinitely. And our best estimate of very long-term inflation outlooks is for them to remain anchored not too far from central bank inflation targets. However, our conviction, shared by market consensus, is that the medium-term impact of the pandemic will add to a disinflationary outlook with inflation remaining at 1.5% and 1% on average over the next five years respectively for the US and the Eurozone.
Central bank support
Major central banks are continuing to implement unprecedented accommodative policy measures to counter virus-related weakness, albeit with marginal easing expected going forward. The Federal Reserve is maintaining its policy although it has now introduced average inflation targeting. Meanwhile the ECB has significantly extended its quantitative easing (QE) programme. Elsewhere the Bank of England has extended its own strategy but not opted for negative interest rates, while the Bank of Japan will also likely stick to its current monetary policy.
We have seen very aggressive monetary stimulus compared to the response after the global financial crisis. Central banks have gone further than we might have hoped, and to the extent that there is now limited scope to push longer-term market rates lower. This helps explain why we have seen more use of forward guidance in central bank communications – the Fed has signalled no rate rises until at least 2024 and we expect the ECB to follow the Fed in reviewing its inflation target.
Fiscal policy should remain supportive. We expect more government stimulus in the key regions continuing over the next 12 months, after an initial aggressive response that relied more on support measures – such as furlough schemes and emergency funding – than long-term growth drivers. The measures have pushed debt levels towards historic highs, but low rates make those levels relatively sustainable. One risk in this scenario is complacency, but we expect governments will seek to reduce debt as we go forward, if only to create room for manoeuvre in the future. This will likely follow conventional debt reduction methods and as such should takes decades rather than years.
Political drama endures
As far as Brexit is concerned, economic and political logic still call for a ‘pragmatic’ solution in the UK’s negotiations with the European Union (EU) – although policy error remains a risk. We expect the process to go down to the wire, but with the UK likely to make concessions which allow the government to make good on promises to deliver a deal. This would also mitigate some of the negative economic effects. Our estimate is that a ’no-deal’ scenario would shave around 1% off the UK’s economic growth next year when compared to a free trade agreement with the EU.
Joe Biden’s victory in the US Presidential Election was welcomed by markets and his administration is likely to materially change the course of policy making. He and Vice President-elect Kamala Harris have suggested four areas that they will focus on in the short term - pandemic response, the economy, racial injustice and climate change. The Senate outcome looks likely to be only decided in January, following a run-off election for two seats in Georgia, but at this stage it appears difficult for the Democrats to win both run-off elections - which would thus deliver a Republican-majority Senate. So far, there is little evidence to support any of the Trump team claims of infringement.
Regarding economics and markets, Biden’s manifesto promised considerable fiscal stimulus over the medium term that would have gone a long way to boost GDP growth and reduce the need for monetary policy support. This now looks unlikely and likely will leave the US economy reliant on monetary policy support for longer. From a markets perspective, the Democrats’ failure (for now) to take control of the Senate is keeping in check the most contentious of their platform on regulation and tax that could have weighed on earnings. On trade, we expect Biden to follow a more multilateral approach - and he may use the removal of tariffs as a key path to re-engage with China over specific issues.
Equity outlook – The future still looks bright
We do not think that valuations are stretched given the rates of underlying growth and exceptionally low bond yields. Regarding our central macroeconomic scenario for the next five years, we assume a nominal GDP growth of roughly 3% (1.3% real GDP growth and 1.4% inflation). We suppose a 1.5 multiplier between nominal GDP growth and top-line growth which means that 3% nominal GDP growth should translate into 4.5% revenue growth (annualised). This 1.5 multiplier is linked to several factors, ranging from the percentage of revenues carried out oversees (roughly 30% for the US), a significant sector bias for the S&P 500 compared to the US economy, and survivor bias for equity index all of which naturally inflates revenues compared to GDP.
Profit margins are likely to be slightly under pressure due to numerous factors, including wage growth and a potential increase in tax rates to finance deficits. We assume a 0.2% decline in profit margins from 8.8% to 8.6% over the next five-years - a 2% contraction in percentage terms over five years, i.e. a 0.4% per year impact on earnings per share (EPS).
Buybacks represent historically a 2.5% boost per year for EPS growth, by reducing the number of shares (de-equitisation).[viii] We suppose that in a (post) COVID world, this boost should decline to 1.5% EPS per year over the next five years.
As a result, we expect approximate EPS growth of 5.5% (4.5% - 0.4% + 1.5%) per year. Valuation-wise, policy rates are expected to remain very low, at 0.4% on average over the next five years. Consequently, the very low discount rate should lift valuations, with a target price/earnings ratio at 23, from 20 currently, in five years’ time. This implies that valuation multiples are expected to expand by 12% over five years, adding roughly 2% to equity return per annum. The dividend yield is around 2% currently and should remain stable with pay-out ratio still constant at 40%[ix].
All in all, we anticipate a total return of around 9.5% per year over the coming three to five years for US equities.
European Union leaders’ ambitious €750bn Recovery Fund, alongside a €1,074bn long-term budget for 2021 to 2027 are welcome.[x] They should continue to drive a rerating of the Eurozone’s value-heavy markets. There is a gradual and positive shift occurring, which will see the share of technology and health care sectors rising in European markets.
Our economists’ view is that Eurozone nominal GDP should grow by 1.5% on average over the next five years (0.5% real GDP growth and 0.9% inflation), which translates into 2.2% top line growth for large-cap companies in the region using a similar approach as in the US (e.g. more than 50% of Eurostoxx companies’ revenues are carried out overseas).[xi]
We expect profit margins to expand from 5.4% to 6% over five years as they partially recover from their crisis level (+1.8% annualised). Buybacks and de-equitisation in general are historically weaker in the Eurozone versus the US, as companies prefer to pay dividends rather than buying back their shares. This limited de-equitisation is still assumed to lift EPS growth by 0.5% per year. Altogether, given that earnings per share growth equals top line growth plus margin expansion plus the impact of de-equitisation, we expect 4.5% EPS growth. The dividend yield in the Eurozone is 3.5%, i.e. investors get on average €0.035 in dividends for each euro invested in equities, a 3.5% dividend return.[xii] With the same line of reasoning as for the US, we suppose that valuation multiples rise and reach 19 from 17, implying a 7% valuation expansion over a five-year horizon, i.e. roughly a 1.5% contribution per year to equity returns.
As is the case with the US we expect Eurozone equities to deliver a total return of some 9.5% per year over the coming three to five years (4.5% earnings growth + 3.5% dividend yield + 1.5% valuation expansion).
Fixed Income outlook
We believe core government bond yields are set for a continued and prolonged period of weakness, as is currently reflected in forward bond curves and market projections for central bank policy rates. Nominal core government bond yields can be decomposed into two components. First there is the expected average nominal short-term rates over the lifetime of the bond. Second, there is the term premium that can be decomposed into a real-rate term premium – compensation which investors require to hold a long-maturity bond rather than rolling over short-maturity bonds. In addition, there is an inflation risk premium, which can potentially compensate investors for holding a financial asset which is subject to inflation risks. Below, we review these different two factors for the US and for the Eurozone.
The expected average nominal short-term rate
The expected average nominal short-term rate is basically influenced by monetary policy - both current central bank policy rates and market expectation of how these policy rates will evolve. Presently, the Fed has made it clear that it will maintain its short-term nominal rate at zero, until at least end-2023, even if inflation were to rise. The ECB is even more constrained to maintain extremely low yields. Indeed, as described in the macroeconomic section, given the medium-term scarring effect of the crisis on economic activity, inflation will likely remain low compared to historical standards and below the Fed’s and ECB’s targets for a prolonged period of time, with respectively 1.5% and 1% average inflation over the next five years for the US and the Eurozone in our central scenario.
Even more so, despite massive intervention through liquidity injections, central banks have consistently failed to reach their target inflation, dampening their credibility. Both growth and credibility issues will continue to weigh on the underlying market inflation expectations which will therefore remain below long-term average, at 1% and 1.5% over the next five years for the US and the Eurozone - excluding the inflation risk premium. Therefore, policymakers will be forced to keep policy rates low. Moreover, with rising debt burdens and servicing costs, there is no appetite to raise rates.
In this context, with the Fed Funds rate at 0% until end-2023 and only gradually rising afterward in our central scenario, we see the expected short-term rate component of 10-year US nominal bond yield rising very gradually from roughly 1.5% currently to 2.2% in five years’ time. In the Eurozone, the ECB’s policy rate should be maintained at -0.5% until end-2023 and then gradually hike toward 0% by the end of 2025 and barely increasing afterward, leaving the expected short-term rate component of 10-year German nominal bond yield 0.5% above current level, in line with what the forward curve is currently pricing.
The term premium
This risk premium depends critically on investor risk aversion, government bond demand from price-insensitive agents like central banks, and the perceived risk of an unexpected inflation shock.
With regards to the second point, government bond demand, in recent years the implementation from central banks of nonstandard policy measures given the persistently weak dynamics in inflation and inflation expectations has hammered this risk premium by artificially increasing the demand pressure on safe assets. The term premium has now turned negative globally, an inversion compared to the conventional framework as investors are now paying a premium for their long-term commitment instead of demanding compensation for the uncertainty regarding the evolution of expected short-term rates. Central banks are likely to continue to heavily weigh on the term premium with their ongoing massive asset purchase programmes, but also because QE will be followed by a phase of reinvestment. Therefore, the part of the outstanding long-term central government bonds which are not held by central banks, will remain at low levels.
In terms of inflation, usually when there is the risk of higher-than-expected inflation, investors demand extra compensation for this risk, which increases the inflation risk premium. However, in our central scenario investors should remain concerned for a long time that deflationary pressures will still be prevalent and that there is a significant probability of having lower-than-expected inflation, e.g. even lower than the expected 1% in the Eurozone, keeping the inflation risk premium very low and below its historical average. In this context, the normalisation of the term premium should be limited - projected at -0.5% for 10-year Treasuries and 10-year Bunds on average in five-years’ time, from roughly -1% currently.
All in all, factoring in the different components, we expect 10-year US bond yields to average 1.7% in five years’ time. In Europe, we expect Bund yields to rise gradually toward 0.5% in five years’ time.
Credit markets were far from immune to the COVID-19 shock, where the widening in spreads has been the sharpest on record. But equally remarkable was the spread recovery. Even more so than for equities and government bonds, two competing forces will determine the path for credit spreads that we see range-bound over the next three to five years.
On one side central banks will continue to intervene massively in credit markets, particularly in Europe, while on the other side the shock on the real economy will impact the profile of current and expected defaults. Factoring in these two elements, we have an average target at 120 basis points (bps) for European investment grade (IG) credit spreads and 150bps for US investment grade credit spreads, close to current levels and at low levels compared to historical standards.
In terms of returns, for euro corporate credit we expect -0.5% annualised over the next five years but for the US we anticipate -0.2% (hedged back to euro).
Central bank dominance will continue to prevail in credit markets. In the Eurozone, the ECB is likely to extend and expand the pandemic bond-buying programme (PEPP) through the end of 2021, with an implied increase by €400bn of its size, while reinvestment of the maturing corporate bonds bought during the programme should continue to at least the end of 2023.
The explicit goal of this financial repression is to further ease financial conditions in the Eurozone, which are not yet back to their pre-crisis levels, particularly through credit spreads compression. The announcement of the credit programme embedded in the PEPP has been very effective at reducing the borrowing cost of the corporate sector. In an environment of low growth and inflation, we see the ECB being forced to continue its support to corporates for many years. In this context investment grade credit appears as much a policy instrument as an asset class with risk.
Despite relatively limited corporate bond purchases by the Fed through its corporate credit facilities, the financial repression is mainly operating in the US by exacerbating investors’ thirst for yield. With US 10-year yields narrowing the gap to other G4 markets, we expect them to remain at these low levels. In addition, with $14trn of global negative yielding debt[xiv] - the entire German government debt curve now trades below zero - investors will continue to consider diversifying bond portfolios with IG long duration credit, which still offers better carry. Even more so that with central banks efforts to suppress bond market volatility, corporate bonds risk-adjusted yields are, in our view good, despite the low yields.
On the other side, in such an uneven period of recovery from the initial shock earlier this year, default rates will continue to be under pressure. However, so far, trailing default rates have risen albeit to a much lesser extent than was experienced in the aftermath of the 2009 financial crisis. They are unlikely to be higher than normal recessions levels, which is noteworthy given the violence of the economic contraction.
This is particularly true in Europe where we forecast a remarkably low 4% default rate for high yield. In the US, bank loan loss reserves and US high yield default rates are pointing to a credit cycle that is currently less than half as severe as the one seen during the previous crisis with limited increase expected from here. These relatively low default rates are a natural consequence of the plethora of support measures deployed by central banks and governments.
Thanks to the resulting ability of companies to access liquidity, non-financial companies have raised a massive amount of cash across bond and loan markets. For instance, according to ECB data, French corporates have raised liquidity equivalent to 9% of French GDP (as of Q2 GDP).[xv] Over five years, defaults are likely to stay artificially low as we expect government bond yields to remain well below nominal GDP, leading to a low default ‘zombie economy’.
We expect the US dollar (USD) to continue to weaken. The Fed is now complementing its massive liquidity injection with average-inflation targeting. Overall, we have a five-year target of 1.3 for the EUR/USD, versus 1.18 currently for the following reasons. First and foremost, rate differentials matter for long-term USD cycles, despite changing sensitivity. With global policy rates now effectively equalised (or close to), as the Fed has aggressively reduced its policy rate, rate differentials between the US and other currencies point to USD weakness. Indeed, higher US policy rates relative to the rest of the world essentially limited the currency hedging of USD-denominated assets from foreign savers as hedging dollar positions was prohibitive. These unhedged capital flows have inflated the USD. This should change now that the cost has dramatically declined, and investors are likely to hedge a much larger part of their USD-denominated assets, triggering selling pressures on the USD.
Moreover, this rate differential also discouraged material speculative short USD positions because of the negative carry. Now that policy rates have converged, our models based on interest rates differentials suggest that the USD could be more than 15% above fair value. A different valuation approach based on the purchasing power parity of the USD versus the euro implies that the greenback currently sits around 10% above its long-term fair value. In addition, the US fiscal balance is set to deteriorate massively, and this will require financing. The mechanism by which foreign investors can be compensated for worsening US fundamentals is either via higher interest rates and/or a lower exchange rate. Given the strong grip of the Fed on the US Treasury curve, the adjustment is likely to be seen through a weaker USD rather than in increase in the US bond yields.
All in all, we expect a significant part of this apparent over-valuation of the USD to correct, leading it to depreciate by nearly 10% over the next three years, to 1.3 versus the euro.
Future challenges for multi-asset investors
The COVID-19 crisis has led to a significant acceleration of trends, many of which were already well established. These include a decline in potential growth and inflation, as well as massive monetary and fiscal policy intervention, leading to an explosion of central bank liquidity injections and government debt.
As a result, we expect the factors which prevailed before the crisis to be magnified and amplified going forward. Bond yields and corporate bond spreads should remain extremely low for an extended period, limiting the amplitude and volatility of their returns. In addition, this will also mean that equity valuations will likely be inflated by the massive excess liquidity in the system, contributing to a large share of the high single-digit annualised total return we expect. The US dollar will likely be collateral damage, ending its multi-year bull market. This, in turn, creates an opportunity and an incentive for investors to review their strategic asset allocation. A summary of our five-year expected annualised returns (including our view on the US dollar for US equity returns unhedged in euro) and volatility assumptions are displayed in the chart below.
Five-year expected annualised return and volatility
Source: AXA IM, November 2020
To gauge the consequences of this asset price inflation in a world of disinflation, we carry out a hypothetical exercise for illustrative purpose. We first determine what would have been the ex-post optimal portfolio over the last 10 years for a euro-based investor, i.e. the strategy which would have generated a higher risk-adjusted return since 2010. Then we use the aforementioned target returns for the different asset classes and determine what the ex-ante optimal multi-asset portfolios would look like. In other words, the portfolios that would maximise the Sharpe ratio of a euro-based investor with the same level of expected return as the ex-post optimal portfolio delivered over the last 10 years, with US equities currency hedged or not - taking into account the diversification benefits provided by different assets. The results are displayed in the table below.*
(* The investment universe in this illustration is composed of US equities unhedged in EUR, EMU equities, EUR IG corporate bonds, US IG corporate bonds hedged in EUR, seven to 10-year German bonds, seven to 10-year US bonds hedged in EUR. In the second column of the table, we use US equities hedged in EUR instead of unhedged in EUR. The last 10-year optimal portfolio is the portfolio that maximises the Sharpe ratio over the 29/10/2010 – 23/10/2020 period. The forward-looking optimal strategic asset allocation is the portfolio that minimises volatility for the same level of expected return as the last 10-year optimal portfolio observed return, based on our five-year return forecasts and our Financial Engineering team’s volatility and correlation estimates)
One striking result of this analysis is the notable increase in the weight of equities in the optimal strategy. This is because equities could continue to post high single-digit total returns despite nominal economic growth being weaker in a post COVID-19 world. Central banks are ensuring that what is lost by equity markets on the earnings side, is more than compensated by inflated valuations. The lower weight of government bonds is a result of the very poor returns expected from this asset class, due to the extremely low level of yields, with US and German bond yields close to all-time lows. Also, with bond yields already very low, their capacity to diversify and protect portfolios is naturally reduced, which make them less desirable from a risk perspective.
Similarly, US dollar exposure, perceived as a safe asset, has historically helped non-US investors during ‘risk-off’ episodes. However, with the recent dollar weakness expected to extend over the next three to five years, the optimal allocation to the currency is lower, as shown by the superior expected Sharpe ratio of the fully hedged portfolio. In this context, higher equity allocations and reduced diversification benefits are likely to increase portfolio risk, especially in the event of growth shocks, which is shown by the significant increase in the expected volatility compared to the last 10-year optimal portfolio.
Ultimately, what we have outlined here regarding the long-term impact of COVID-19 on growth, inflation and investment returns, hopefully clearly demonstrates that there are multiple forces at play, requiring a deep understanding of the broader investment universe in order to maximise potential returns.
[i] AXA IM 2020 (27 December 2019: 3.86 / 20 March 2020: 149.33 / 23 January 2009: 82.06)
[ii] AXA IM 2020
[iii] MSCI World Total return index in EUR, Bloomberg data as at 31 March 2020
[iv] MSCI World Total return index in EUR, Bloomberg data as at 11 November 2020
[v] FTSE World Government Bond Index-Developed Markets; currency-hedged in EUR terms, Bloomberg data as at 11 November 2020
[viii] AXA IM 2020
[ix] MSCI Data, 30 June 2020
[xii] MSCI data / AXA IM
[xiii] Reuters October 2020
[xiv] Trustnet / BofA Global Markets, OECD Capital Market Series Dataset (2019), FactSet, Thomson Reuters, Bloomberg
[xv] European Central Bank - Financial Stability Review
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