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Mid-Year Market Update: The Risks and Opportunities Ahead

First Republic Private Wealth Management
July 16, 2021

Watch a virtual mid-year market update and discussion focused on the risks and opportunities ahead, featuring Christopher J. Wolfe, Chief Investment Officer at First Republic Private Wealth Management, and Mike Selfridge, Chief Banking Officer at First Republic Bank.

Read below for a full transcript of the conversation. 

Mike Selfridge - Okay, good afternoon everyone. And thank you for joining us here at First Republic Bank. This is our quarterly update and it's always my pleasure to host Markets Update with Christopher Wolfe. My name is Mike Selfridge, I am the Chief Banking Officer at First Republic Bank. And Christopher Wolfe is our Chief Investment Officer at First Republic Investment Management. He oversees the research and strategy of our investment management group. Which as of our results yesterday, if you saw topped $241 billion. So Chris is a real testament to you and the team and your leadership and all that you're doing for First Republic clients. So we appreciate that. Just a quick background on Chris, he's a influencer in my opinion and I think everyone else's in the world of economics, in money management. Many of you may have seen Christopher on television, interviews or in various publications. What I'm going to do is ask Chris a series of questions, but you'll see a Q and A button at the bottom of your screen there. And if you would like go ahead and submit questions and after about 20 or 30 minutes, I'll get to those questions if I hadn't already answered them. And other than that, let's get started. So Christopher, great to see you.

Christopher Wolfe - Nice to see you, Mike.

Mike - You know, I was thinking, we've been doing this every quarter and I went back to one of our first episodes of this, back to, it was actually a year ago. And I'm just kind of thinking of, what we've all been through. So a year ago, we were at 11% unemployment, we were in the midst of starting the stimulus machine going, the tenure treasury was 50 basis points, and the GDP was the worst we'd sort of seen in a few generations, negative 33% print for the second quarter. And of course, as we went throughout the year, things started to recover. Vaccines were invented, distributed. And all the while many asset classes where we're seeing quite a bit of appreciation. And as you developed your theme for 2021, we came across the theme of A Tale of Two Bridges for this year. And those two bridges we're the stimulus bridge, I think we've checked the box, but I'll ask you that question. And then the vaccine bridge, which of course a year ago, we didn't have a vaccine. And I think as of right now, we're just under 60% administrations of at least one shot of vaccines in the United States, and global vaccination continues to increase. So ironically, Christopher, it is National Tape Measure Day. So let's measure your performance in terms of how you did. And are you still sticking to that theme of A Tale of Two Bridges as we look forward?

Christopher - You know, by the first part of this year, we thought it would be over a little bit faster, but I think the challenge here is twofold. The first is the Delta variants, the Lambda variants and other, I think, challenges around the vaccination rate not increasing faster. I'll leave a wide gap between the most vaccinated states like Vermont, and the least vaccinated states like Mississippi, et cetera. I think the one encouraging piece around the vaccination story in the US is just from an economic perspective, I leave it only there. By GDP, the wake of GDP in this country, very large proportion is vaccinated. And the big contributors like California, New York and others, are continuing to accelerate their reopening. So, confidence around an economic story, that's tied to the healthcare bridge more broadly is still very, very high given some of those data points. But it is concerning what we see going on in the Delta variants. Bottom line though, to your question, we're going to need the healthcare bridge to be buttressed and support as the year continues. And more importantly, those bridges need to get built more strongly around the world. Original estimate was that we'd see, the rest of the world six months behind the vaccination programs at work. And boy, is that really off. At a minimum, we're like a year behind for the rest of the world. So that miss, I think on our part is something that we're trying to recalibrate. It should affect the way we think about asset allocation, hardest hit areas, kind of rebound, but that delay, that lag in year, is probably one of the bigger misses for this year.

Mike - So are you going to revise that theme, you're going to wait for the two bridges to be built? And kind of looking forward, what do you think is the next theme for Christopher Wolfe and First Republic Investment Management? Maybe it's too soon to call.

Christopher - Yeah, it's a little too soon. We usually do a big annual review towards the end of the year. So it'll be kind of noodling on this through October, November and published something in December and January, kind of an initial position and then as a starting point. So, I would say the things that are coming up now are, you know, moving beyond the two bridges, would be inflation, that's going to be the hot topic, we think, for several years at this point and we'll talk about that. You know, the kind of peak in policy and profits and stimulus and all those things and what happens in the aftermath and ensuing market volatility. So, looking for catchy phrases around that. But those are, I think, some of the bigger issues that we'll focus on. Not that COVID will go away, but I think the reality is there's also some other structural changes that are happening. I think of a world now with US and China, in a place where there's two of everything, there's likely to be some demand and infrastructure builds, likely inflationary that will create persistence. So I don't know why we're stuck on the letter P, but persistence of inflation is probably going to be one of those themes.

Mike - We've had every letter in the alphabet now for the recovery. So you touched on the bugaboo, we're going to get to inflation. But before we get there, I want to kind of set the table here for, you know, global growth and US GDP growth. And then we'll get into some of the mechanics behind that. And then of course, I think inflation is on everyone's mind. And including ours. And so we'll sort of dig behind the inflation numbers and what we think that means and where it's headed. Gross domestic product, United States, we clocked in about 6.4% in Q1. I think the estimates for Q2 are probably over 7% and for the year actually looks pretty good. So, if you just sort of fill in the blanks here on GDP for the year, how does it look in terms of the recovery.

Christopher - Without a major disruption, I think seven, seven and a half is in the bag. I think our original hope, but the very high end, we'd probably see something closer to nine, nine and a half is being tempered quite a bit. The reconciliation process and kind of the political function around stimulus is going to hamstring that a bit. But that's okay, there's a consequence for all that stimulus. That's all the debt. And we're going to touch on that too. So seven, seven and a half is still an astoundingly good number. The interesting thing is it looks like it's going to also lead into 2022, which is a good thing. It's going to be a long lag story, so 22 should be an above average GDP here as well. So that's a good stage, I think, for investors to think about, you know, an economy that's doing relatively well. And maybe one of the upside risks is an overheating economy. You know, frankly unlikely at this moment, but it's one of those things that we think about. So good year for 21, I think that's in the bag without some major disruption.

Even if we go through a reconciliation process around the additional stimulus, I think it's really the bleed of the 2022. Many of these programs have longer tails to them. I think the critical component though, is going to be watching that jobs data, and both the unemployment, the underemployment, and interestingly enough, increasingly the quits data. Which is very high 4 million plus quitting jobs. That's usually a sign of a healthy labor market, so I think there's going to be some consternation of quit rates stay very, very high. And whether or not that leads to kind of a worker strike and looking for higher wages. So that story is going to play out through the balance of this year. Particularly as we see a number of states cutting benefits, some states maintaining benefits, and that story's starting to just play out now. Too early to read it. A lot of folks want to read, you know, two data points and call the trend. We want to be a bit more circumspect and kind of let those things develop through the summer. It's a messy time for labor markets. It's really going to be about back to school. By September, October, we're going to know, what that kind of cut the benefits are not trend look like in terms of job fulfillment. And I think there's a little bit a ways to go there.

Mike - And we're still, I think the last numbers I saw that you printed, we're about 7 million jobs shy of what we lost. I think we lost almost 22 million jobs. But the speed of the recovery of the jobs compared to '08, '09, '08, '09 it took almost five years to gain our jobs back. So we're still short, but we're recovering. And so to your point is still a little too soon to tell in terms of how we get those back.

Christopher - I think so. because what's new this time are the direct to consumer stimulus checks. You know, we didn't have something of the same scale back then. So the newness is both in terms of the size and the breadth of what we've been underwriting. I think the challenge around that is that gets a rethink for how folks are thinking about the jobs that are available. Seven out of every 10 jobs in the service industry. Many of those were kind of minimum wage type jobs. And, you know, the reality is humans are rational. They'll make comparisons between what can I get, you know, doing one thing, maybe collecting money, versus another thing working. And they'll make some tradeoffs around that. Unfortunately it's not always about just money. It's also about the time spent and other things involved. So I think that calculus that folks want to save, because this then that, if you give a benefit and not go back to work, there's other things that go on here that COVID has created, whether it's higher gas prices for example, or kind of a higher car prices. Do you have a car to get back to work? So, I suspect it's going to be messier, these last 7 million jobs, I suspect, will be harder to recover. And we'll be talking about them for quite a period. Keep in mind underneath this is something called underemployment. Folks working jobs that they may not want to be in and are qualified to do something else. So if you add that plus the emergency measures that are still in place, we're actually talking about quite a lot of people that could still be in the labor force in a very full and productive way, but are not.

Mike - The economy is driven almost 70% by the consumer in the United States. You used the word possible; I think overheating. And if you didn't say that, I'm going to put those words in your mouth. But if you look at the consumer, and granted this has been a recovery that's been very in equal. It's been one of inequality. But having said that, consumer net worth is now at an unprecedented all-time high, it's $144 trillion. And it was about 115 trillion before the pandemic. The excess savings on the balance sheets of consumers, over the average savings rate of say 8% is almost $2 trillion. This sentiment of consumers, it continues to increase. The demand is increasing. Feels to me like good times are ahead for quite a while when you stir that all up and put it into the GDP pot.

Christopher - Well, that's one of the underpinnings for a longer-term more persistent element of inflation. You have a huge pool of savings, you have unfilled jobs, you have workers, if you look at some of the recent surveys, feeling the most optimistic they felt nine plus years, something like that. You're in a place where we could be in a relatively good economic period. Even though a stimulus makes it look exaggeratedly strong, probably not a word, in an exaggerated way, it looks strong. But the bottom line here is that the kind of the bleed into 2022, still above trend. And by the way, if things continue, again, without major disruptions, you could still see some pretty good growth even in 2023. But we're going to be talking in 2022 about policy changes and how much stimulus is left in the system and those kinds of things. And the market will react to that. So, I think there'll be a growing divide between market and economy. Where the economy may actually do relatively well, but the market's built in a lot of good news. Doesn't mean things are bad, just a lot of good news is built in. Market has seen some of the good things you've just talked about, Mike.

Mike - So a further push on this and then, I want to drill into inflation. Stimulus. So I think, I think, we're close to 28% of our Gross Domestic Product, either committed or to be committed in terms of stimulus. Another tailwind, right? The stimulus is working its way through the economy, it lags. So in addition to the consumer confidence and consumer savings, you now top that with government spending. injected into the economy. What are your thoughts on the stimulus and the effect on the economy going forward?

Christopher - It's likely to be a long in terms of its effects, not only this year, but the last well into next year, number one. Number two, at least in the current political environment, there's likely to be some wrangling to get a lot of it done going into midterms next year, and without bringing too much politics into market conversations, because you don't really need them, it will be important when we think about just the headline GDP numbers and ultimately, where is the stimulus directed? A lot of the human infrastructure elements that are currently proposed in President Biden's plan are things that are hard for, I think, the entirety of Congress to get their heads around. And so, that's going to create the reconciliation process, voting on party lines. And it will mean that the trade offs that are required to make reconciliation work, will probably lower the total value of how we think about stimulus, ultimately getting into the economy. But even if you take the lowest Republican estimates as an example, you're still a trillion plus. You may kind of split things between one and three and a half and get to a two-plus trillion number, there's just a lot of money and no other way to cut it that's coming down the pike between here and the next five to seven years.

Mike - I've mentioned in the past, you had made some comments on this notion of modern monetary theory. And if I get it right, in other words, if you're the world's currency, you can really print as much debt as you want and pay the bills. And I guess, I mean, at what point is it too much in terms of stimulus and debt? The global debt, I think for the world is now about 105% of global GDP, $92 trillion. And it was significantly below that in the past. So, I mean, this is just a punchbowl that doesn't go away.

Christopher - Keeps on giving. So kind of can stay drunk if you want, you can be drunk if you want. Without having cliche things, I think the critical issue is this, increasingly what debt is becoming is more of a political question than a true financing question. The use of debt so long as the financing rates are sufficiently low, is something that we're going to see economies try to take advantage of. And in particular, where you have things like senior rates, the ability to print your own money to buy your own debt, we used to call it monetizing the debt, you know, in the United States way back when. But as long as you have that ability, you're going to see, I think, Japan 30 years ago, be the hallmark for where things are likely to head, lots of money sloshing around the system, rules and regulations that don't let it all out so you don't get wildfire inflation. An aging population base that may benefit from this. Inflation elements that show up in all sorts of markets, capital markets inflating, real estate markets inflating. So, we have lots of excesses of funds floating around. That's what it tends to do, find its way at the margin to increase the prices of things. And that's where you get back to the inflation story.

So the MMT angle ends up being a political angle at the very end. And so we may look for how many Tea Partiers get reelected or get elected in Congress in the next several cycles, that's spells the end of MMT because that changes the way that we think about whether or not we're going to print money until there's some other element. The other thing that changes MMT is crowding out. The idea that you end up having interest payments as you accumulate debt that are so large, that they consume almost of your budget or elements of your budget. Keep in mind, the US has got 4 trillion plus give or take in tax revenues. And we're going to spend seven trillions, something like that this year. That's clearly unsustainable, but could we spend four and a half trillion for a bunch of years? Yeah, probably as long as the financing costs are low. Right now, where the United States is, is there is a reasonable gap between insolvency and bankruptcy. One is the kind of assets more than liabilities, and other kind of the ability to service your debt. We are servicing the debt. Most other nations are as well for that senior reach function. And the fact that rates are very, very low. I think about it this way, this experiment, you know, Mario Draghi, we're going to take interest rates to uncharted level, started in 2008 and it's still ongoing 14 years later. 13 years later. So we're in a place where, what Reinhart Rogoff called financial repression. We're this deep into it, where you have things like negative real interest rates. That's when the yield on your bond minus the yield on inflation is negative. And it's there for a very long period of time.

You're squashing the savings function, you're punishing savers. That's what financial repression is. Punish savers to reward investors. And that period that we've been in for the last 10 years is unlikely to change at least for the next several years. So back to your modern monetary theory point, which is it ends up being political. And ultimately what's happening with this punishment of savers and rewards to investors, as long as the conditions are set, which we think they will be, to continue on that pathway, and NMT is kind of the backstop or at least the thinking related to it. because Jerome Powell, Chairman of the Fed, would never say that's the activity. The reality is the presses are on. And you're in a place where it will take the will of Congress to change things like debt ceiling or other elements related to the way they have debt or debt servicing, before, I think there's a real major issue. In the meantime markets will fret and worry, but as long as the regime stays like it is, they're likely to be propelled a bit ahead. And traditional concerns like inflation or other things will still be important but at the end of the day, it's still an asset story and investment story rather than a saving story.

Mike - So that's interesting. And then back to the global debt, I guess it's a worry, it's just a worry down the road. So we'll deal with that in a couple of years or a decade.

Christopher - Yeah and this isn't a glib response, the issue is this is a regime change. It's not a trend change. It's the whole regime has to change with respect to whether or not excesses of debt are going to be important from a political standpoint and economies want to tackle them. There's a little bit here that the longer this goes on, the less likely it is to be solvable and the less likely is to be solvable, the more likely it won't get solved. So the links in that chain are starting to build and if you don't solve it, you find out at the end, oh gosh, this is a very large kind of tipping point. What some people call Minsky moments in financial markets. So the idea here is that, as long as the regime stays like it is, it can go on and it's likely to go on at least for the next several years.

Mike - So the congressional budget office of the United States just came out, I think the other day, and they're projecting the debt held by the public is now 102% of Gross Domestic Product. They forecast it, it will be 202% by 2050, which tells me, they're actually thinking ahead that we're just going to continue to head down this path of increased debt.

Christopher - Wow, I think they drew two through two lines on a chart and said, it's going up. You know, the reality is, they have to make some baseline projections. If we assume nothing changes, you know, all else being equal, X is likely to happen because the changes are potentially infinite, future is unknowable and certain, a lot of things could happen. There could be climate issues between here and there that create inflationary problems that changed the way we think about budget deficits. There could be other issues the way infrastructure builds are required if we're going to have two technology and competing political systems between the US and China. So, I think baselines are fun to look at, they're frankly very scary at the moment. I wouldn't pay a lot of attention to them. Really, the next three to five is kind of the more appropriate cycle, at least from a government planning standpoint.

Mike - Yeah. All right. Let's get into the big one, inflation. I have been traveling around, I'm in Boston today, was in Jackson, Wyoming. They can't find help for restaurants and hotels in Jackson, other parts of the country right now, the stats as you've seen recently come out the consumer price index now yesterday, I think came out at a 4.4% in the core amount of four and a half percent, that's excluding food and energy. Although I don't know why we exclude food and energy, we all need that. But having said that, the Fed has, they had revised a year ago, actually their target from 2% to an average of 2%, the producer price index that just printed today for June came out at 7.3%. extraordinary inflation numbers coming in well above what the Fed is targeting, and Chairman Powell was on the television today talking about, you know, transitory and expects to revert to the mean and the bond market as well. The tenure treasury today at 135 is yawning on the inflation story. So are we missing something here with inflation or some of this is going to stick and continue forward? And if it does, what happens from the Fed's perspective with rates?

Christopher - So the root of that is at least around financial markets, responding to inflation. Who'd think we'd have 7% GDP print and a 130 on the tenure? That's just backwards. Rule changes or rules in particular are forcing that related to the way banks need the whole capital, et cetera, but we'll come back to that in a minute. So the inflation story is difficult because on two levels the same thing is happening. There's something called the Bullwhip Effect, which is small changes in demand at the very end of the supply chain can have wild changes all the way upstream in Silicon foundries and that kind of stuff. This is well documented in the tech sector. And what you've seen is, as everybody went to work from home, you have all sorts of things that when you work from home electronics, phones, iPads, computers that demand computer chips and because the computer chips these days are so complicated, you have to submit your order like six months, eight months in advance and you've gotta wait, you know, however many months to get it. It's like there are a long lead and lag times in getting your product, even though there's massive global capacity. The fact is, you know, if the average density of chips in the phone is, you know, you're talking about 2030, going up to a hundred or more, you need way more chips than you originally thought. On top of that, cars are just becoming moving computers.

So you can get to a place where at the end of the day, the COVID surge driving everybody home and driving lots of kind of high volume easy to purchase electronics sucked most of the supply of chips through the system. And you just can't build a new foundry tomorrow, chip foundries cost three to 5 billion to start, and they need to be scaler. So why would I bring all this up? Because chip foundries and the challenges around getting kind of Silicon through the system, you know, from basic chips to complicated chips, to program chips with very specifics, you know, General Motors chips are different than Ford chips, all that and securing capacity. And the fact that we have lingering effects in a trade war with China, all kind of co-mingled because by the way, China is a huge producer of Silicon, and also a huge user and when we're fighting with them, one of the things that tends to happen is, well, we're not going to supply so much Silicon and silly, we put tariffs on Silicon as well. So in any case, why is this all important? Because if you look at the inflation numbers, you can get to things like used car prices and consumer electronics that added one percentage point or more, maybe 1.5%, 1.6% to the inflation numbers that we're seeing. So how long will chip shortages last? Well, car productions ramping up, foundries that are adding to their capacity lines are ramping up, unless we have COVID again, we're not going to go on a whole other wave of buying phones and iPads. So, now Apple's managed it by staging their production runs. And I think that what we're going to see is some tapering of the big inflation numbers.

The second thing that's happened is oil prices. Energies explained the other 1.8% of the rise that we've seen at least in consumer prices. Well, I'm not blowing this off because I think there are some important inflation elements going on. The big headline, scary numbers I think abate by the time we get to middle of next year, supply chains will be ramping up a bit at that point and sooner or later, the discipline that the oil industry seems to be exhibiting right now will break. And you're going to watch things like, the Baker Hughes rig count data, which by the way, in the peak of kind of oil drilling back at oil at a hundred bucks in 2011 and '12, we had 1600 rigs, you know, under the ground drilling for oil, we've got like 380 right now. It's nothing, it's a nothing burger. So sooner or later at certain levels of oil prices capacity is going to come back online because the rigs are sitting there ready to go. So why would I bring this together? It's not to say that, well, let's just wash away inflation. There are some real effects going on at the pump. It's going to take six to eight months for the inflation data to work out. The food price inflation that we're experiencing now, mostly driven by climate change and supply disruptions and transportation worker shortages, that's going to take long too. That's at least another six months. The chip shortage that's probably a year.

So what I'm telling you is I think the narrative for the Fed should actually better be interpreted from it's transitory, which everybody kind of assumes is short to, it's going to be persistent longer than you think. And really that's going to be the persistence of inflation all the way into 2022, maybe at low levels, you're going to see gas prices stay high through 2022, you'll see food prices and suddenly stay high for 2022. I think that's the thing that humans experience in an economy. That's the thing that will affect confidence. That's something we need to watch closely. So well, the big print now is really just a warning sign. It's more about the persistence average inflation of three or four. That's not great, Fed sweet spots like two, two and a quarter. Now the Bullwhip Effect is when the little changes kind of go all the way through and there's some sub effects for Burbage all that stuff. But what is important about that is, that's the upstream effect in producer prices. Oh geez, some bigger changes in the front end of the consumption. We're all the way into the chain. Now, there's a good and a bad side to higher producer prices. The good side is that that's higher profits for everybody in the chain. So corporate profitability going into not just this year, but into next year, it looks pretty good. So I mean, even though there's going to be higher corporate taxes, companies are going to be able to compensate for it. The bad side of this is where there are supply constraints we're going to see higher inflation equals higher prices and this kind of type of inflation called cost push and we're just going to see it push through the system, which is why it's probably going to be more persistent than maybe the Fed is looking for. And while we're not trying to openly disagree with the Fed, transitory probably really means all the way until the end of 2022, maybe into '23 and in some industries, it might just be a permanent effect, so remains to be seen, but we're planning for higher inflation lasting longer.

Mike - So if you then tie that into the Fed and interest rates, it feels to me, they've sort of messaged pretty well that they'll follow the data but at the same time, they're pretty dovish the rates will stay near zero in terms of the Fed fund, at least through 2022. How patient will they be quarter after quarter reading these transitory inflation numbers before they react, do you think?

Christopher - I think we're going to be well into 2022 before we get to a place where they're hiking rates. It seems likely to us that they're going to get to a place by the end of the year where, taper talk will now be the talk of the market it's kind of being hinted at now, but the bond market's not really adjusting to it. The bond market is telling us something, the accumulation of all this debt is actually dis-inflationary, you're busy repaying your debt, you're not investing to grow, but it also tells you that the risks of runaway spiral inflation, because there's a lot of hand ringing, oh, you know, avocados are up 6% and gasoline is up 40%. We understand that, I'm not diminishing it as much as the expectation that you saw a previous point and a new point and therefore you can see the next point. It's going to go up, that's confirmation and recency bias. We've gotta take that out of the thinking. There are reasons that we should expect some of these prices to taper off between here and next year. At the consumer level, they'll stay somewhere in the range where they are now, but gas prices unlikely without some other major effect to go a lot higher from here but it's important that we think about, you know, not extrapolating too far and just looking at where things are likely to head. So why would that be important? Because if the Fed's talking about taper towards the end of the year, the bond market will start the adjustment process, number one. Number two, if the persistence of inflation remains relatively high, we'd expect that combination taper plus inflation persistence for the bond market to go, Ooh, we should pay attention. And that's really about a story about higher yields.

It's very hard for us to see, although we've been wrong, tenure winds in one three, we did not see that. It's very hard to see from here. Doesn't mean it can't happen, but very hard to see how we don't get to at least one to three quarters to 2% by the end of the year where bond market just needs to make some adjustments. And that would be fueled interestingly enough, by how you see demand for loans, housing and the banking sector. So for the Fed to give you a sense that the front end of the curve as well anchored, they're telling you negative rates are going to be here, savers are going to be punished and you're still in an investing world. That's that regime comment I made earlier. I think the reaction around what bank rules are likely to do bank profitability, their ability to buy extra debt, means that, you know, the buying function for all the debt and that's likely to becoming may need more enticement. And you know, when enticement in bond land looks like, higher yields. I think that's where we're heading.

Mike - You mentioned negative rates a few times, and if you adjust the tenure treasury for inflation, whatever that number is for inflation now, we are at negative rates in the United States.

Christopher - Have been for a while.

Mike - Yeah and it sounds like that would continue. So again, to your thesis, it's going to continue to favor borrowers, including the US government and punish savers?

Christopher - Yes, a strong word, but that's where we are.

Mike - So take that into consideration and talk about the liquidity and I'm getting to your investment thesis of, where people are finding yield now, because you're not going to get it in a bank savings account and are people in pursuit of yield, you're not going to get it in the US treasury market. What does that mean in terms of how you're allocating client's funds as it relates to generating a yield that would be something north of 1.4%?

Christopher - Very, very difficult, particularly as many corporations these days have not upped their dividend policies to keep pace with where we see tenure or kind of the inflation story. So, natural yields out there, whether it's in coupons or dividends stories are much harder to come by. They're all kind of relatively high priced. I think, structured yield elements, you're seeing a migration of, you know, structured products, for example, you know, where it's appropriate, things that are higher yielding for structural reasons. We've added leverage like closed in funds, for example, I think that product driven yield story is, the best gen that one of the last that we're going to continue to see investors move towards not in order to capture the yield that they're looking for. So I think the challenge is this, is that the savings function is increasingly requiring you to, if you want, meaning yield, is increasingly requiring an investor to take on more and more equity like risk. I think the simple question should be, well, if I'm going to take on equity risks, shouldn't I get an equity return? Why don't I take on equity risk and only get 4%, if seven or 10 or something else is available? So it's not a backhanded way of saying sell all your bonds because the risk of kind of liquidity and not having a portfolio to rebalance is super important. We find that some clients chasing yield so hard, they put all their money in private investments. And boy, I hope that works out, I really hope it does, but if it doesn't, the cost of being wrong is incredibly, incredibly high. And the other thing that's happening here is, if you just do a little bit of the math and the Biden tax plan, and you talk about taxation for individuals, many of our clients would still be okay in high tax states like New York and California communities, and by, okay I mean they'd probably get a slight positive return, not that much, but a slight positive.

Mike - You have an acronym, ANGIE, Alternative's Not Good Enough Yet, remind us what that is and are alternatives good enough now?

Christopher - Yeah, that means it's the version of the other acronym called TINA, There Is No Alternative, I mean, no alternative to investing. So the alternatives to investing meaning savings are not good enough yet. You're not in any way, shape or form near an alternative to investing. So there's no rebalancing function at kind of the system level from investing stocks and kind of to a lesser extent bonds or private investments, et cetera, into a savings function, which is typically cash or shorter term, you know, bonds of that nature. There's no payoff there. And it's going to take a very long time. Typically you need an alternative to provide a real yield, a yield after inflation of one to 2%. That's where some folks get excited. It's another way of saying, Hey, look, if the 10-year bond we're at 6% right now, boy, that would attract a lot of folks, but we're not there for a lot of the rules I mentioned at the very beginning. Banks having to ensure that they have sufficient amounts of tier one capital. They're kind of generating excess profits. They're using those excess profits to do what? Buy tier one capital. What's tier one capital? Treasuries. So there's a little bit of a virtuous circle and there's other elements associated with that story. But the bottom line here is that, the rule function and the safety function, even for other big institutional investors is still very high. So without a bigger supply of these things, you get a lot of this distortion in the market with a 10-year bond at a low level and you get, you know, inflation numbers running relatively high. I'll close with this, if patience's a backward-looking number, our expectation given that tapering here is that inflation kind of settles in the two and a half to three range, somewhere between here and 2023 and that's part of the adjustment path for the tenure. So even though we're talking about things in the moment, markets look ahead and that's where I think we need to be looking.

Mike - So I do want to get into the markets and your thoughts on the valuation. Before I get there, this notion of lots of liquidity, endless pursuit of yield, which you're not going to get at banks, as I mentioned, liquidity market, a year ago, when we did this, I think Door Dash just went public and lots of IPO's. They were up 86% in one day. Again, a huge demand for yield, SPACs or Special Purpose Acquisition Companies, the fashionable new way to go public, I think there were a billion dollars in transactions in 2013, last year, 83 billion in SPACs and year to date, 113 billion, lots of money moving around, searching for yield and maybe just some thoughts on the market in general before we get into the valuation of the market itself.

Christopher - Well, you know, a lot of learned folks tie things like excessive speculation, structural complexity, and those kinds of things to, you know, markets that are likely to not provide the kind of return that investors are looking for. And, well, that's a nice prognostication, I would frame it in a slightly different way. There's a lot of rules out there that the new structures and other things are trying to compensate for, number one, number two, that ANGIE's story is still a fairly powerful one. If you want to accomplish a series of financial goals, there aren't a lot of alternatives, at least in this market, but that said, the stock market on average has built in a lot of really good news. And I think if you're looking at between here and in the next year, while the profits story is very good, markets' also relatively high doesn't mean it's going to crash although the infrequency of market corrections is a little troubling. We are way out of historical norms at a lot of ways, because we just haven't seen a lot of 10% corrections, which should be happening in normal markets with more frequency. They don't, it's one of those signs that the Fed is distorting everything as some folks think about it. But as I related earlier, our view is that the regime that's in place, monetary and fiscal stimulus arrows pointing the same direction that tends to reward investors, not savers. It's likely to stay in place all the way through 2022, profits stories likely to be good. If you're an investor, it's hard to imagine a better environment in that. And that makes sense because the stock market's been bid up.

What we believe may be happening though at this point is that, with the good news largely built in, we see a market that will probably be a bit more choppy, a bit more volatile between here and the end of the year as inflation volatility. You just mentioned a couple of numbers today. Taper talk comes in because, oh, well the end defense stimulus, I should be careful. Remember the simple rule is follow the Fed. And then we get into 2022 and we're going to actually examine what the corporate profitability looks like and on top of that, there's going to be an election cycle. And it's not clear where things are going to lean at this point and what policy changes may ensue. So I think for investors, the idea that market returns might be more muted isn't a bad one, but you know what, lift up the covers, there's likely to be a lot of interesting opportunities. The steeper yield curve, pretty good for financials for example. Technology stories, you work off the Foundry capacity and supply story, you're going to see a resurgence here. Interestingly enough, the tail end of that could be a disinflation or deflation in that space, could be a very interesting workout for many of the tech companies, bigger profits, because now there's an excess of chips by the time we get to '23, '22, '23, something like that, some of the industrials and economically cyclically sensitive sectors still look pretty good. There's a lot of naysayers all of a sudden, because they think a combination of inflation and maybe growth isn't as high as they wanted, seven's still good. I heard somebody talk about stagflation already and you know, that requires a big timeout, we're ways away from stagflation. So the story here around investing is still pretty good to my second point and I think you're going to end up lifting up the covers of markets and being more thematic and more targeted in sectors, you know, going forward and that there's still room for some of these areas to improve like the ones that I mentioned.

Mike - Are you changing your, I'm going to go on to equities here in the S&P 500, you mentioned corporate earnings, which are so far this quarter and in the past quarter, coming in extremely strong, the price earnings multiplied when we did this a year ago, I think went from a 13 times for earnings per share now up to we're over 20 times earnings, the S&P 500 itself, I think is up 37% year over year. I mean, that's a lot of growth and it feels very toppy. So you're sort of reallocating or rethinking the way you're allocating portfolios as it relates to equities or fixed income or alternatives.

Christopher - Well, so here's the three big themes in a world where you expect more persistent inflation, in a world where some of the hardest hit areas should recover, in a world where we're flooding stimulus stillness system and it hasn't filtered its way all the way through the data yet, although we're seeing some price increases which are good. Number one, you probably keep your bond portfolio relatively short. We've done that, oh, that's been painful as the yields have gone down, they went against us, but I suspect as the year will evolve, bond portfolios will rebound a bit, at least relatively speaking. I think two is, as I mentioned, the stay at home strategy that we talked about in our first go around about a year ago, we've modified a bit, we've reduced our, you know, really strong focus on the US to look for opportunities outside the US for the next couple of years by rebalancing portfolios. That means adding more international, adding a little bit more emerging markets, still some big concerns there, but mostly around international on the thesis that we would see bigger recovery and guess what, financial sectors, which is a big player outside the US and just more broadly consumption.

We were early. I think we're early. We talked about that last year. We implemented some of the changes end of last year, beginning of this year and I think the reality is, instead of being only six months behind the US, non-US markets are a year or more behind the US. So we're going to stick with this because the relative valuation is still good, but I think that's our biggest opportunity going forward. At least around the big allocation is to reduce the stay at home bias and look for those opportunities globally, in the midst of things that look pretty difficult. The last piece is the stimulus story has a long way to go. It isn’t over yet and no, all the good news isn't built in. So economically sensitive, you know, materials, industrials, and the financials, that kind of thing, still elements of kind of lift up the covers and where would I focus more of my attention and efforts. And we're doing that in some of the portfolio. So those are the big themes that we're using to address markets. I think beyond that, you know, the growth in private markets has been absolutely astounding. We're now approaching two and a half, almost $2.7 trillion and kind of dry powder across in recycling powder across most of the private markets. And, you know, the biggest opportunity for many clients from me is, assessing their liquidity budget. How much money could you tie up after this big bull run and the recovery from COVID and things that could be a little bit private offer, a different return pattern and a different exposure, you know, attract a floor plan financing in Iowa, for example, making that up, water pipelines in Southern Texas, because the aquifers are becoming more saline. So there's lots of interesting things going on in private markets that you don't always capture in public markets, but, you know, sometimes you do. I mentioned kind of carbon pricing, for example, with in the past, this was really a private markets focus, but carbon credit pricing has gone in a very strong direction. So thematic elements that are off the beaten path are also important for the way to think about diversification when savers are punished, and investors are rewarded.

Mike - So Chris, I'm going to start grabbing some of the Q and A from our attendees here and within the 240 billion in assets under management under First Republic Investment Management, that you also oversee our alternatives group and that's access to, you mentioned private funds, it could be credit, could be private equity and real estate. And so a specific question on your thoughts around commercial real estate and other things that you may be seeing on the real estate side.

Christopher - Yeah. You know, there was a lot of speculation the last 18 months that it's overpriced. You gotta sell it and there's big challenges around it. But I think the reality here is that the inflation story, if it's persistent, may show up in a couple of different faces, it could be the regular inflation, the cost push type that stays around for a lot. And by the way, changing your rents every year, every two years, is called rent roll, is a good thing. You want to own real estate in a cycle like that. So that's important. I think there's been a return to that. So we have a reasonably constructive outlook on real estate. It's not the broad based by real estate everywhere, commercial, a little bit more challenging office, really challenging still, not sure all of the kind of post COVID effects are worked through the system but we're housing for sure, rehabilitation, for sure. What is the opportunity zone, a laws thing effects, this is probably the last year you can look at something like that, but, you know, 2022 would be just given the way the laws are written? And I think that we'd also look for maybe apartment and kind of multifamily housing. And as you probably well know or our listeners know well, that real estate markets in certain areas of the country are absolutely haywire. And that the idea that getting the cost of entry to also changing density functions, which are many cities are starting to do are important elements of kind of apartment investing going forward. And those are are likely to be some of the key trends that we see in real estate.

Mike - So we've got a question here on crypto, few questions, it always comes up, Bitcoin had touched 55,000 a coin, I think we're down to just a little over 30,000 a coin. The question was sort of two parts. What are your thoughts on crypto and digital currency? And then I guess there was a stat from JP Morgan they think it's going to be a $40 billion industry, but I haven't heard that, if you add it up, it was a trillion-dollar industry. So, if it's 40 billion, I'm not sure if the question is, is it cratering more, but maybe generally speaking, what is the sort of the research you've done on digital assets as well as crypto?

Christopher - So the interesting thing is digital assets for us, a variant of all the things that are out there broadly as a category. We'd like, we're trying to find ways to invest in them. Bitcoin and all the cryptos are a subsidiary of that. So I think at this point, three things have happened with respect to crypto, number one, the wild west phase is still ongoing. So just keep that in mind. There's no wish coin that the creator was out there saying, you're all crazy today, why are you buying this thing? It's a joke. Then it was there's other coins, which I can't talk about on this call with names that you shouldn't repeat. And again, they're a joke, but if they have astronomical valuation, so we never underestimate the power of machines to follow other people and that kind of stuff, number one, number two, I think at this point, everybody should be aware that crypto whales, at least in respect to Bitcoin, are the ones that control the markets at this point, the ones that invested early and really kind of hype things up with their FID strategy, fear, uncertainty, and doubt all that stuff. And that's an important piece because when a significant proportion of any market is controlled by a few people, that's not a democratized market. It's one that's right for big episodic periods of volatility. I think the last piece is that, you know, Bitcoin in particular seems to be evolving towards a collectible in some ways, the use case for most of these things is still quite challenging and there's a lot of reasons for that. It's not to say bitcoins are going to 5,000, that's not what we're predicting, our expectation is that there's things that aren't necessarily related to fundamentals that are going to move these things around.

There are some, for those that are technically inclined indicators like Metcalf's law, the value of a network and how it grows that can be used to help gauge the value of what some of these coins might be worth. But ultimately, it's all about how I think they're going to be used in transactions, because if they're not used in transactions, then they're just collectibles. So it's really about the transaction function, which there's very limited data on. And frankly, the biggest transaction processes in the world, Visa, MasterCard, they're the ones that are going to be the gatekeepers for a lot of these things. I think the last piece of this puzzle, which we don't understand just yet is that, it is often missed by new technologies, the efficiency of the existing system. You know, back in the day when bank branches, for example, were all the rage to get rid of, JP Morgan was out there saying, oh my God, a fully costed out bank branch is going to give me a 40% return on assets. What are we doing? We should actually have these things. The efficiency of centralization is not zero and the presumption that distributing everything through digital ledgers is always more efficient, it's not one that has been tested yet. So is that a way of seeing that this is likely to take a lot longer to play out?

Yeah. Number two, you're going to have rule changes driven by central banks that will ultimately affect the value of some of these things. And I think number three, you know, we're in a place where it's not just the crypto piece, there's just a much bigger pool of things to look at in digital assets. If you're a collector, there's a whole bunch of interesting NFT stuff, Non-Fungible Tokens, that's what that stands for. And there are transaction patterns being built mostly by central banks, China starting. You've probably seen Chile, Salvador and a few other countries start to try to figure this out. It's creeping in, but it's going to take a long time. Why? Because on the exact opposite side, places like Turkey are saying, oh no, no, we're never going to have this stuff, get this out of here, not a medium transaction. So I think that kind of polarized result means it's not settled yet. And I think mostly when we talk to clients, you need to have, you know, caveat emptor, buyer beware and very small allocations.

Mike - Chris, a few comments on questions, I should say on the tech sector, just your outlook on the tech sector. And there's a specific question on the FAANG Stocks, that's Facebook, Apple, Amazon, Netflix, Google, particularly as it relates to antitrust issues that are going on, but they maybe that's a little too narrow. And so maybe just some general thoughts on innovation and tech as it relates to investing.

Christopher - Well, good news, neutral news is not good news. I think that's the way I look at it. Good news is the cost of innovation, in this country is super low. You know, the idea that you can get from innovation idea to public marketplace or private marketplace is, should be fresh on everyone's mind because you can do that rapidly with universities, funding centers, the growth in the private and venture worlds. That's, I'm super bullish on that. Innovation pace is just going to be astounding. It's helped by the fact that SaaS model, Software as a Service, you can create an app really quick, boom, you can get it out. All sorts of interesting things are happening. That's the great news story, the neutral news is that, okay behind all that, it's so easy to switch and change that there's likely to be lots of disruption and lots of other things going on. So there's not a buy it and forget it mode here. You've gotta be very careful and pay a lot of attention to the space around FAANGs. So let's get to your last point with Fangs. I think the bigger challenge and something that everybody should understand is, we're in an age of hyper aggregation. So think about TikToK, the aggregation of followers, you went from a hundred thousand, you make a cool video, and now you got 6 million followers, the internet and technology more broadly facilitate that.

That's what hyper aggregation looks like. Who wins in that? The hyper aggregators, Amazon, 10 Cent. You know, everybody understands those big aggregators. The challenge with hyper aggregation is not only do they aggregate revenues, et cetera, but they aggregate power, political power, what do most companies do in the United States once they accumulate lots of revenues and lots of savings? They turn to lobbying. They started trying to look for rules and things that help them. That's not a cynical view, that's just the pattern of the way corporate America has worked with the political class in this country. Not a socialist view either. That's just the nature of things. Why is that important? Because the challenge here is that, when they aggregate that much power and you start making sweeping decisions, think about the banning of, you know, Republican writers or whatever on Twitter, et cetera, those kinds of sweeping decisions do truly not at elements of, I think the way people think about not only freedom, but also how are we looking at what these new technologies do to the way we want to interact as people. And I don't know what the right answer is, but I'm pretty sure Jack Dorsey doesn't know the right answer. And the challenge around that is that, Congress and the people should rise to the occasion and make decisions around that. Unfortunately, the long history of United States suggests that the first instance is going to be regulate or not only regulate, but antitrust, that's the first stab at the problem usually. And then after that, it kind of works itself out. But the first cuts the deepest. So it's a big challenge, I think, for the tech industry, by an agenda that would have much more antitrust. I think the good news here, at least from a political standpoint, this gets into the 2022 cycle, there are zero Republicans that are interested in all that kind of stuff at the moment. So if you're counting on the hyper aggregation and the profit story for the FAANGs to not get interrupted by the kind of regulatory environment, it's a reasonable bet at this point, but it's something we've got to watch closely.

Mike - I want to touch on geopolitical and mainly the China story, because it was still a story a year ago that we had just respectably closed both our embassies when we did this a year ago, there's still tensions there, trade tensions and you've got a theme called Two of Everything. And it feels like it's two of the 5G network, two of the eBays, two of the Facebooks, et cetera, et cetera. So what are sort of your thoughts on the backdrop of China relations, the China story and how that plays into investing?

Christopher - Yeah, there was a very small article today, which I find very troubling that the President Biden is going to continue President Trump's pattern of not engaging China in formal ways. And the dialogue between the countries is kind of loose and you know, how to structures, maybe it needs to be, that's not a good sign. So the world of two of everything is problematic on two fronts. The first is it requires infrastructure, different technology standards, it requires expense. Switching costs are high. All of this is both cost time aggravation and potentially inflationary for the user, the end user around it. And we had a little version of this, IBM versus Apple United States. Of course I pick IBM because why would I be wrong if I'm a corporate buyer, but you know, kind of Apple rises to the occasion and then switching costs became impossible. How do you go from Android to Apple? You're just on the phones. It's not pleasant. It's unpleasant.

So the challenge, I think for provisioners or providers in two of everything networks, you know, Huawei in China is one of the biggest buyers of semiconductors and we're kind of in a trade issue, the United States, what should they do? Oh, they should go buy all the capacity from Taiwan semiconductor. Oh, that's shuts out some US players. Well, they do that, now you get into these other things that go on version of economic warfare that I think creates or inflates costs because, oh, I want my capacity in there, Taiwan send me, I'll pay you more to do that. And that has that potentially bullet effect going through the system the other way around, the cost push effect. So why would I highlight that? Really because it gets to the idea that two of everything is likely to be more expensive. The world has been set up to run it 6%, 7% real GDP on an efficient, globally integrated supply chain network with everybody on largely similar approaches and standards. And it is very clear to us at this point that is not the world we're going to be into in the next five to 10 years. It's going to be two standards, at least around technology and infrastructure in a lot of ways, and a world will not be running to the same degree it used to on the same global supply chains, they're going to get safer, but at the expense of cost.

Mike - So another question on oil, which is interesting, it's sort of just silently increased 80% year over year. So I think Western Texas intermediate crude now is $73 a barrel. I mean, that's inflationary and there there's in that question is sort of your thoughts on Shale that it used to be the Shale Revolution but when oil was 40 bucks a barrel, it's sort of not that exciting, but if it sticks here in the 70s it becomes a little more exciting. So general thoughts on maybe energy and oil in particular?

Christopher - Well, despite all the talk about electric cars are still low single digit percentage of the overall kind of or single digit percentage, overall car experience, the United States, gasoline is going to be around for a while despite, you know, a number of shops saying they're going to eliminate them by 2026 to 2030. So we're in 2021, so you have another five years, et cetera. But the reality is removing hydrocarbons from the energy generation chain is really, really hard. They'll end up with, you know, we're not going to have electric, you know, boats for awhile. We're just getting into electric planes, so that's not a bad thing, but the transportation infrastructure requires a lot more than just batteries, requires charging networks and other things in order to kind of substitute for hydrocarbons. And it's very hard unless like at your home level to get away from heating, well, if you're like in Northeast United States, until you put a solar wall on and you have great battery power and even then it's, you know, the sun is not always the most reliable power generator. It's useful, but not always reliable, at least not in the Northeast. So what we would talk about these things, because the oil story here has a few things going on. There has been a huge resurgence in demand. There's a huge car buying that's been going on in the US and around the world. People should travel more, stay at home on a travel as you know, small family knit groups. And that kind of created a surge in the way that energy consumption, gasoline in particular is up same amount. Number two, we've seen strangely supply discipline, the US shale producers. They're only producing an 83% of where they were even a year ago.

Now, some of that well production is kind of falling down, well flow rates have come down a little bit, but there's a lot of uncapped wells out there. And as I mentioned earlier, there's a lot of rigs we could be using. So, the story then is how long will the discipline lasts before supply comes back online? And that Reese is against, well, how quickly will the world recover in terms of COVID and their bridges and Europe and other parts of the world? So our expectations, our prices stay relatively high, but they don't add more to inflation between here and the middle of next year because they already did, they already came off their bottom, unless the oil goes to 150 and gas goes to 550, we're not going to see a huge contribution to inflation, but oil prices probably stay higher. That means that investment in the energy sector is probably likely to pick up into this year kind of going into early next year.

Mike - And Chris, I think, time for one last question that I should have brought this up, it comes from Peggy and it says, it's about how you're investing these days with the ESG, that's Environmental Social and Governance. And then it says, what is First Republic doing about DEI programs? To the latter, I would say you can visit our website, go to About Us and what you'll see there is a corporate social responsibility deck that we put together that gives you all kinds of information on DEI and First Republic. But ESG is a big theme as it relates to how you're investing these days and how big of a deal is that and what influences that having on the market, as it relates to stocks and bonds.

Christopher - Big influence, we have models of strategies that we use with clients. I think increasingly clients want to see the customization that comes with things that might be more specific de-carbonisation trends, for example, or environmental sustainability. Those are actually different animals. They're largely related under the umbrella ESG, but they're different. And your portfolio, depending on how you wanted to construct it would look different in those two things that sounds similar. So the idea behind all of this is, I want to put my values in my portfolio and I want to be able to customize it. And increasingly financial technology is helping to facilitate that. Now we run some models and we have a lot of third-party managers for investors to have that beginning conversation, what do you want to do? But it actually should start a few steps before that, which is what's important to you? And if it's important, how do you want to do it? Environmental, you know, issues de-carbonization important to you? Maybe the first question is, do you drive a Prius and that's not a criticism, but what is important to you and where is it important, are all part of that, how would you work with your wealth manager to see where that belongs in your investment portfolio? Is that it is ESG an indicator of will outperform in the future? Absolutely not. And we like this area, big firms are going there, but it is potentially a form of risk management. And that's probably the key to this, meaning there is some evidence, it's not compelling, but it's some evidence that suggests that companies that are practicing responsibility towards their shareholders, their communities, and towards their employees tend to do a little bit better. You know, the data here is kind of a little bit weak, but there is some indications that, that is important. And if it's important to you, then there are ways to kind of get through that with the financial technology. As Mike, you said on the DEI piece, we have a number of ways on our website that we're talking about that that can be also a form of customization when clients are thinking about what's important to them in their investment portfolios.

Mike - So I know we have two minutes and Nick asked a question, I'm going to ask this and it might be fair, it might be unfair, if you had a million dollars and that's an arbitrary number, he says in cash, to allocate, how would you invest that given today's state of the markets in the world?

Christopher - Oh, all on Black 20. Seriously, I would think about it maybe in three things, if that was not all I had, and it was play money, I might put a lot into the venture and the technology and innovation space that we just see this continuing to be an on fire space for a very long period of time. As long as interest rates are low and the cost of starting a company is through technology is low, it's just going to be a hotbed. So, you have to think about it as a flower garden. You know, maybe 800,000 goes to zero, but the 200,000 is going to go to 3 million bucks, something like that. So that's the case in situation one. Situation two is I needed it for future income. Well, then I'd do something different. If I need it for future income and I had to invest it, I would look at it still in a fairly balanced way. I might be more tilted towards equities and alternatives, but I still have some bonds. So if I were more balanced, I might have 25% to 30% in bonds, you know, a good 50% or so in inequities and all the remainder in kind of private types of investments that generated returns and income outside what the public markets would give me, whether it's in real estate, some of these mezzanine kind of financing elements, I'd look for structures that provided me income as well. And that kind of diversification looks far beyond the stock and bond story, I think most folks have been tied to. That's really where I'd be going.

Mike - So Christopher Wolfe, Chief Investment Officer, First Republic Investment Management. Thank you, I always feel smarter coming out of these than I did going into them. And it's just a lot of wisdom and great insight. For our clients on the line joining us first, this recording will be made available on our public website in addition to the transcript. And secondly, if you have any questions or just want to get insight on Christopher's latest thinking and research, please contact your First Republic relationship manager, wealth advisor or investment manager. And we'll be happy to connect you with that. So with that again, thank you for joining us and Christopher, thank you so much.

Christopher - Michael, thank you. Thank you everyone.

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