"When you combine ignorance and leverage, you get some pretty interesting results." - Warren Buffett
While enjoying some much-needed R&R (Rest & Recuperation) basking under the sun far away (hence our lack of posting recently), we still managed to look at market gyrations with the continuation of outflows from US High Yield as well as weaknesses in Investment Grade Credit. When it came to selecting our title analogy for this first 2nd Quarter musing, we reminded ourselves, of "Fandango" being a lively couples dance from Spain usually in triple meter, traditionally accompanied by guitars, castanets or hand-clapping which can be sung and danced. The "fandangos grandes" (big fandangos) are normally danced by couples, which start out slowly with gradually increasing tempo. Many varieties are derived from this one. As a result of the extravagant features of the dance, the word "Fandango" is used as a synonym for "a quarrel," "a big fuss," or "a brilliant exploit." Given the return of heightened volatility in 2018, following years of "financial repression" from our central bankers/planners, we thought our analogy would be appropriate given the earliest "Fandango" melody dates from 1705, and was probably the first "dance battle" and it also appeared also in the third-act finale of Mozart's opera Le nozze di Figaro (1786). As we reiterated in our early March conversation "Intermezzo" CITI's Chuck Prince had a nice dancing analogy in July 2007:
"When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing" - Chuck Prince
We also added at the time:
"To some extent, early market jitters such as the ones caused by the explosion of the pig's "short-vol" house of straw amounted to an "intermezzo" we think. A larger musical work is at play and it is the evolution of the credit cycle. It is slowly and gradually turning, with macro hard data erring on the soft side recently (US durable goods orders falling 3.7% in Jan, vs 2.0% drop expected) while consumer confidence, being soft data, printing on the strong side. When it comes to liquidity, it is being withdrawn by the Fed through its "Quantitative Tightening" (QT)." - source Macronomics, March 2018
Although Spanish in origin, "Fandango" is one of the main folk dances in Portugal. The choreography is quite simple: on its more frequent setting two male dancers face each other, dancing and tap-dancing one at each time, showing which one has the most lightness and repertoire of feet changes in the tap-dancing. While one of the dancers dances, the other just "goes along." Afterwards, they "both drag their feet for a while" until the other one takes his turn. They stay there, disputing, seeing which one of them makes the feet transitions more eye-catching. Obviously, current "market transitions" are becoming more and more "eye-catching" with the relative surge of volatility noticed in 2018, particularly with weakening "soft data" such as consumer confidence hence our "musical" analogy title.
In this week's conversation, we would like to look again at US corporate fund flows as well as US corporate leverage in conjunction with the rising trade war rhetoric which, as we indicated in various previous conversations is "bullish" for gold.
- Macro and Credit - Fandango and leverage don't mix very well
- Final chart - US labor market still impaired by low productivity growth
- Macro and Credit - Fandango and leverage don't mix very well
While the short-vol pigs house of straw was the first casualty in the "capital structure" thanks to the change of the "volatility" narrative, it seems to us more and more that we are witnessing as well the gradual end of the "Goldilocks" environment which has prevailed for so long in somewhat "bulletproof" credit markets. All in all, it appears that the three bears namely inflation expectations, rising volatility and trade protectionism are coming after "Goldilocks." The second quarter is therefore starting on a much more tactical note which according to us needs some rethinking surrounding "asset allocation". If indeed "Fandango" means a clear return of volatility in 2018, then it makes sense overall to reduce your beta exposure across equities and credit and raising some cash levels in the process. Sure some pundits would like to point out the solid macro backdrop thanks to strong growth expectations as we move into "earnings" season, but, given the rising tensions surrounding the "trade war" narrative, it represents serious headwinds should things escalate quickly between China and the United States.
There is no doubt in our mind that the credit cycle is slowly turning, while many pundits are focusing their attention towards the "technical" spike in the Libor-OIS spread, we would rather focus our attention on flows and fund outflows. We have to confide that we are part of the crowd that believes QT could prove to be inflationary as we indicated back in February 2018. On the subject of QE evolving towards QT, we read with interest Bank of America Merrill Lynch Credit Market Strategist note from the 29th of March entitled "On the road from QE to QT":
While QE was wonderful and led to favorable technicals in the form of too much money chasing too few bonds, QT (quantitative tightening) is the opposite - i.e. leads to unfavorable technicals and periods of too many bonds chasing too few investors. While QE suppressed volatility and led to a buy-the-dip mentality, QT is the opposite - i.e. higher volatility and sell-the-dip. While under QE fundamental erosion did not matter and strategists were king, under QT companies better not disappoint and analysts are king. Our outlook piece described 2018 as a year where the technical deteriorate, although due to plentiful foreign QE market conditions remain relatively orderly - despite US QT - even though volatility increases (see: 2018 US High Grade Outlook: Long analysts, short strategists 21 November 2017).
Such view is clearly playing out as at times - such as in March - this year's decline in supply is insufficient to mitigate the decline in demand and spreads move wider. Next month (April) we are due to swing in the other direction with partial retracement of recent weakness, as supply declines - not just corporate bonds but more broadly and globally - while demand is supported more by the start to Japan's new fiscal year (though smaller than in previous years due to the high cost of dollar hedging). But keep in mind that this year technicals are impaired on a more permanent basis and rebounding supply in May - and more weakness in the front end of the curve as the corporate investor outlines plans for reducing cash positions - should lead to renewed spread widening pressures.
The trillion dollar challenge
Figure 1 and Figure 2 below show our updated view of US fixed Income technicals in 2018 - refer to Figures 7 and 8 in our outlook piece. For full details of this analysis please see our above referenced 2018 outlook piece. Assuming 25% less foreign buying in 2018 compared with 2017 (down 50% for corporate bonds based on YTD net dealer to affiliate volumes and flat for Treasuries based on our rates strategists' view), 51% lower inflows to bond funds and ETFs (implied by our model for HG bond fund/ETF flows, see: Credit Market Strategist: Inflows to taper 26 January 2018) given how the year began), the Fed's balance sheet reduction and our forecasted fixed income net supply we see a relatively balanced market in 2017 where other investors only had to net buy about $181bn. However 2018 looks far less balanced with a need to attract roughly $973bn of additional money throughout the year, but especially in 2H. Our view remains that this requires meaningfully higher yields - obviously we have that already and expect further increases on the road to 3.25% on the 10-year by year-end. Add the coming pension rotation and chances are we will see limited further yield pressures.
Less is more
As expected supply volumes accelerated to $124bn in March from $98bn priced in February. That puts supply in March of this year 5% below $131bn issued in March of 2017. However, unlike in 2017 supply is weighing much more on spreads this year. The ICE BofAML high grade index is 15bps wider month-to-date, compared to 1bp of spread widening over the same period last year. The difference is that this year the seasonal acceleration in supply coincided with much weaker demand. The two biggest sources of demand for high grade corporate bonds - foreign investors and bond funds and ETFs - declined by close to a half compared to 2017. First, dealer selling to affiliates, which is a proxy for foreign demand, was down 47% in March of this year compared to 2017 (Figure 3).
Similarly, inflows to mutual funds and ETFs (based on daily reports that account for about 50% of the total AUM) are down 66% so far in March relative to the same period last year (Figure 4).
Hence the current period is similar to the spring and summer of 2015, when supply volumes accelerated in an environment of slowing mutual fund and ETF inflows, leading to wider spreads (Figure 5).
Just as in 2015 secondary market spreads of high grade issuers announcing new issue bond deals underperformed significantly. Weaker secondary spreads for issuers coming to the primary market highlight the role of supply in driving the general market spread wider (Figure 6).
- source Bank of America Merrill Lynch
What matters to us, when it comes to our concerns relative to further credit spread widening obviously is the weaker tone in fund flows as reported as well in the latest Bank of America Merrill Lynch Follow the Flow note from the 3rd of April:
"Outflows from IG, HY and equities
European IG, HY and equity funds have recorded outflows last week, during a broader risk off trend. The trend was worsened with outflows from equities tripling w-o-w, while outflows from IG have more than doubled. Within credit in particular, wider spreads amid an influx of new deals over the past weeks has not been supportive for high grade fund flows.
Over the past week…
High grade fund flows remained on negative territory for a second week in a row. However we think that the flow trend has worsened more than what the underlying trends in rate vol and spreads would entail. We think that flows should improve going forwards into a quieter April-May period.
High yield funds continued to record outflows (20th consecutive week). Looking into the domicile breakdown, outflows have been recorded across the board last week, with the majority of it coming out of US and Globally-focused funds.
Government bond funds recorded their 11th consecutive week of inflows as investors have been reaching for "safety", amid Trade Wars and falling risk assets. All in all,
Fixed Income funds flows remained on negative territory for a second week in a row. European equity funds continued to record outflows for a third consecutive week; with outflows tripling over the past week. Last week's outflow was the largest since July 2016." - source Bank of America Merrill Lynch
What matters for more stability in US Investment Grade Credit could indeed be a reprieve in bond volatility but there is as well we think something that needs close monitoring which is, the importance of foreign flows and in particular Japanese flows. This IS a point we approached in various conversations. US credit benefits from a very important support from the Japanese investing crowd as per our July 2017 conversation "The Butterfly effect":
For Japanese investors increasing purchases in foreign credit markets has been an option. Like in 2004-2006 Fed rate hiking cycle, Japanese investors had the option of either increasing exposure to lower rated credit instruments outside Japan or taking on currency risk. During that last cycle they lowered the ratio of currency hedged investments.
One thing that appears clear to us is that USD corporate credit in recent years has been supported by a large contingent of foreign investors in particular Japan. Reading through UBS Credit Strategy note from the 21st of July entitled "Where are we in the credit cycle?" we were pleasantly surprised that indeed, Bondzilla the NIRP monster is "made in Japan" and it is as well a critical support of US credit markets:
"Our deep dive analysis isolates Japan as the critical support for US credit"
- source UBS
Where we disagree with UBS is that according to their presentation, because of a divergence in short-term rates is increasing hedging costs, they believe that the yield advantage of FX-hedged US IG credit is eroding and therefore the foreign bid is set to unwind due to these dollars hedging costs. As we posited above, during the 2004-2006 Fed rate hiking cycle, Japanese foreign investors lowered their ratio of currency hedged investments and sacrificed currency risk for credit risk." - source Macronomics, July 2017
While we disagreed at the time, thinking it was too early when it comes to the advantage of FX-Hedged US IG credit, given that in the Fed rate hiking cycle Japanese investors sacrificed currency risk for credit risk. It is worth noting that since the beginning of the year, Japanese flows have been waning and this is a cause for concern when it comes to the stability of Investment Grade flows and credit spreads we think. This is highlighted in the below chart from Nomura from their FX Insights note from the 26th of March entitled "Who will be left behind?"
- source Nomura
This might be due to the end of the Japanese fiscal year and might be a temporary weakness but, we think going forward, this will be very important to track when it comes to assessing the strength of the US Investment Grade credit market.
As pointed out by our friend Edward J Casey in his latest March Credit Observations on Linkedin, it is important to track the Credit ETF Arrhythmia:
"The waves of an EKG quickly allow your doctor to see how well your heart is functioning. Credit spreads perform a similar function, allowing us to see signs of market stress or strain. After recovering from February's volatility spike, credit is closing wider for the quarter. Spreads remain well within healthy trading ranges, but the ETF arrhythmia is worth closely monitoring. Year to date LQD, HYG & JNK have experienced over $12 billion of outflows, shrinking assets by -18%" - source Edward J Casey, March Credit Observations
We could not agree more, in this accelerating Fandango. Flows and outflows matter more and more as many are dancing closer and closer towards the exit it seems in this gradually tightening environment thanks to the Fed's hiking path. In a late business cycle, with the Fed in a normalization process in conjunction with rising volatility, this could lead to a carry trade unwind, making it less likely carry return will turn positive and this could provide additional headwind for US credit we think. While Libor-OIS has been the recent focus for many pundits, watching cross-currency basis matters, particularly USD/JPY for US credit support.
The consequences from ZIRP to NIRP in both Europe and Japan have provided a strong critical support to US credit in recent years as indicated by Deutsche Bank's (DB) note by Torsten Slok entitled "Risks to US credit from April entitled "Risks to US credit from higher inflation, more Treasury supply, ECB exit, and higher hedging costs for foreigners":
"A lot of money moving from Europe into US fixed income
US investors have no appetite for foreign bonds
Foreigners hunting yield in the US after interest rates turned negative in Europe and Japan
Foreigners are now the biggest holders of IG, HY, and loans
ECB exit and higher US Treasury yields leading to less demand from abroad for US IG
Since QE started credit quality has deteriorated
- source Deutsche Bank
As we pointed out in our bullet point, "Fandango" (rapid outflows) and leverage generally do not mix very well together, particularly when liquidity on banks' balance sheet has been dwindling in recent years, making the exit door even more tinier that what it used to be even during the Great Financial Crisis (GFC).
The question, therefore, one needs to ask in the face of rising aversion for US Investment Grade is where do we stand in terms of "leverage"? On that particular point we read with interest UBS's take from their Global Strategy note from the 19th of March entitled "Is US corporate leverage higher than reported?":
"Is US corporate leverage higher than reported? The health of corporate balance sheets, particularly speculative grade and private firms, was one of the key thematic debates during our client visits in London. We break down the genesis of the questions into three sub-themes: first, within the US corporate credit markets where are the excesses? Second, how concerned are you about levels of leverage, and to what extent are earnings add-backs hiding risks? And third, what early warning signals are you monitoring and what is the current outlook?
Where are corporate credit market excesses?
We have previously outlined three corporate credit market imbalances that bear close tracking, with the latter two in focus in this piece. First, in high grade the rise in lower-rated, longer dated issuance with the ratio of BBB/BB 10yr+ debt rising from 4.8x to 13.3x. Second, in speculative grade a doubling in the number of triple C rated issuers to over 1,400 (US corporate debt: revisiting financial stability concerns). A majority of these issuers have funding in the US leveraged loan market, issuing secured loans to boost issue level ratings; B-rated loans outstanding have risen from $195bn to $467bn since 2012 (Figure 1).
And third, above average debt growth in the technology, electronics and pharmaceutical sectors; for US leveraged loans specifically this thesis is evident in the growth of the broad manufacturing and sectors which have grown from $117 to $295bn and $256 to $448bn, respectively, since 2012 (Figure 2).
By sub-industry growth, manufacturing has been primarily electronics ($124bn from $52bn). In services, business services ($98bn from $77bn) and lodging/ leisure ($87bn vs. $52bn) have led the increase.
More recently, we have discussed lower rated firms as structurally more vulnerable to rising interest rates with near-peak leverage and relatively low interest coverage (Lesson Learned: The Underbelly of US Tightening). And we argued that $1.1trn of lower rated, spec grade loans were the fulcrum - i.e., more vulnerable to our house interest rate outlook characterized by aggressive Fed rate hikes (7 through '19) but significant yield curve flattening (with 5yr Treasuries projected to remain below 3% through '19). Our analysis suggested these issuers would be resilient to 3-4 Fed rate hikes, but 4 more would lower coverage ratios near pre-crisis ('06) levels (A deeper dive into US credit markets more vulnerable to aggressive Fed hikes).
How concerning are leverage levels, and are earnings add-backs hiding risks
US leveraged loan gross issuance hit a record of approximately $500bn in 2017, with about 60% of use of proceeds for leveraged buyouts (LBOs), M&A/acquisition or recapitalizations (Figure 3).
While the theme of LBOs is less prevalent this cycle vs the prior, M&A has been a more persistent theme - primarily between private/sponsor firms. The market has been a sellers/borrowers market in recent months, in part driven by duration concerns which are fueling inflows into floating rate products (The Technical Pulse: Where will yield-hungry investors next leave their global footprint?), the perceived safety of secured debt and financial deregulation (with bank adherence to the 2013 Leveraged Lending Guidance fading). While median total leverage metrics have declined from peak levels of 5x to 4.5x post-crisis, they are still above the 4.25-4.5x pre-crisis. In addition, the negative tail remains fatter as the proportion of issuers with leverage above 6x is 29% (vs a post-crisis high of 35%, and 19% pre-crisis).
To reiterate, these figures represent the median leverage for public leveraged loan issuers outstanding (i.e., leverage on the stock of public issuer loans). But 65% of the lev loans are actually from private firms. While we do not have median leverage data on the stock of private issuer loans outstanding, credit metrics are available on all new deals - public and private (i.e., the flow). This data shows average total leverage for all deals at 5x, with private leverage running at 5.2x (c1x higher than on new public deals). Total leverage on new private deals has been running above 5x on average since early 2014; in the last cycle, average leverage above 5x was seen from Mar '07 to Mar '08 (Figure 4).
Across the capital structure, however, leverage through the 1st lien for all new deals is at 3.9x, and has been running higher than prior peaks since 2013 - one key reason why lev loan investors have heightened recovery rate concerns in this cycle (Figure 5).
But what if leverage (and coverage) figures are wrong? The issue of earnings adjustments (or engineering) has consistently reared its ugly head in our client discussions for several years, and it is certainly not confined to US leveraged loans - but the rhetoric from leveraged finance/distressed credit investors has grown stronger. Market participants suggest nearly every acquisition-related deal now has its share of EBITDA add-backs, and a number of long term investors have suggested this cycle is unlike any others they have witnessed. Figure 6 depicts our best estimate of the average EBITDA add-back (expressed as a turn of total leverage) for M&A deals over time.
We would posit that the phenomenon of EBITDA add-backs is partly an unintended consequence of macroprudential regulation. The 2013 Leveraged Lending Guidelines (not enforced until late 20147) capped pro forma leverage at 6x (and required 50% debt amortization within 5-7 years), incentivizing issuers to manage pro forma EBITDA such that leverage would remain below the 6x threshold. Rising add-backs are likely also a byproduct of low interest rates and QE, which have pushed up asset valuations and M&A deal multiples and contributed to reach-for-yield behaviour and material easing in lending standards.
Aggregate data on the magnitude of EBITDA add-backs is not easily sourced. For this we have leveraged the work of Covenant Review, and more specifically data from their CR Trendlines Topical Reports. Their work suggests that EBITDA addbacks for M&A - related deals across sponsor/ non-sponsor deals in 2017 were approximately 20-21% of Pro Forma Adjusted EBITDA. In 2017, the tendency seemed to be greater add-backs appeared first among large sponsor deals, and then spread across mid-sized and non-sponsored loans. And in 2018 this seems to be taking shape again, as EBITDA add-backs for M&A-related deals for large sponsors are averaging 26% of Pro Forma Adjusted EBITDA - suggesting another "high water mark" for EBITDA add-backs is attempting to take shape now (as addbacks for mid-sized sponsored/ non-sponsored loans remain at 20 - 21%).
Finally, in terms of sector outliers, the magnitude of EBITDA add-backs is more aggressive in electronics, software, metals/mining and food/food services (ranging from 24 - 29%). Are the add-backs being realized? The verdict is still out. First, it is difficult to monitor the aggregate credit fundamentals for the stock of private loans post-deal. Second, the credit agreement and covenants typically allow borrowers 24 months or more to realize a majority of the add-backs, in part a function of the significant easing in lending standards post-crisis (consistent with the shift from covenant to covenant-lite loans, 75% in '17 vs. 29% in '07; Figure 7).
For illustrative purposes, if one assumes a liberal view that all add-backs are realized then leverage levels are unchanged; however, if one takes a conservative view and excludes add-backs, total and 1st lien new deal leverage would increase to 5.0x and 6.2x, respectively, on average from 3.9x and 4.9x, respectively (Figure 8).
What early warning signals are you monitoring and what is the prognosis?
At this point, we don't see an inflection in the credit cycle. First, leveraged loans (1.35%) have outperformed high yield bonds (-0.52%) year-to-date amid higher rate and equity volatility, and LL spreads remain firm at 368bp (4yr discounted spread) even as LL default rates tick up moderately to 2.2% from a low of 1.4% in August (Figure 9).
Second, we have also created a proprietary non-bank LL liquidity indicator, following the methodology of our non-bank liquidity indicator (Credit Cycle Turning? Non-bank Liquidity Hits Multi-Year Lows), which calibrates changes in net loan issuance for low quality credits to determine if lenders are starting to ration their existing liquidity to higher quality borrowers. Historically, this proxy proved to be a warning signal in Q3 2007 and Q4 2014 when net tightening in lending standards reached +5 to 10% while spreads were still relatively tight (Figure 10).
Currently the indicator is at -2%, indicative of net easing and a constructive backdrop in the LL primary market.
Third, in terms of market structure and sector risks, the key demand source in terms of flow and stock of LL is collateralized debt obligations (CLOs, Figure 11).
And CLO portfolio exposures can be quite diverse, suggesting investors should pay attention to concentration risks. In this respect, we are focused on the outlook for technology (13-15% average exposure in CLOs), mainly software given robust debt growth, M&A activity and EBITDA add-backs and, secondarily, the healthcare (11-12%) and cable/media (8-9%) industries10. YTD total returns in these sectors are lagging the overall index modestly (electronics 0.90%, healthcare 1.12%, cable television 0.86%), but remain positive overall.
Lastly and more broadly, bank and non-bank lending standards are not showing signs of tightening credit, our proprietary credit-based recession gauge is a modest 13% through Q3 '18, and broader US credit valuations look 0.8 standard deviations rich (vs. 2 standard deviations back in Q2 '07; Where are we in the credit cycle?)." - source UBS
For UBS it appears that "Goldilocks" has not run its course, yet one thing is for certain as we posited in November in both our conversations "Stress concentration" and "The Roots of Coincidence" where we argued that we were starting to see cracks in the credit narrative thanks to rising dispersion at the issuer level as well as growing negative basis credit index wise. We added that rising dispersion meant better alpha generation from pure active credit players, particularly in the light of rising M&A activity in 2018. The trend in dispersion we discussed as well in our previous conversation is indicative that investors have become much more discerning at the issuer level, this is a sign that the narrative in credit markets is slowly but surely changing as the rhythm in the "Fandango" increases we think.
With the upcoming release of the US nonfarm payroll numbers, as per our final chart we think that the US labor market is still being impaired by low productivity and hysterisis.
- Final chart - US labor market still impaired by low productivity growth
Hysteresis in unemployment can generally be observed when businesses switch to automation during a market downturn. Workers without the skills required to operate this machinery or newly installed technology will find themselves unemployable when the economy starts recovering. In effect, loss of job skills causes a movement of workers from a cyclical unemployment stage to a structural unemployment group. Our final chart comes from Bank of America Merrill Lynch Liquid Insight note from the 30th of March entitled "US labor market still looks polarized" and displays the US labor market polarization with the US adding more jobs for high and low skilled occupations relative to middle-skilled ones:
"Polarization" in the job market-where high-skilled and low-skilled work has grown, but middle-skilled and middle-class employment has stagnated-may be a crucial feature in explaining why historically low unemployment has failed to generate substantial wage growth so far. This adds to the long list of factors explaining the disconnect between the low unemployment rate and slow wage growth. As we have argued in past research, we think slow wage growth reflects, in part, the low productivity environment, compositional shifts in the labor force and a change in the structure of compensation packages. The persistence of polarization in the job market throughout this recovery is another reason for the only slow growth in overall wages. It is also another reason the FOMC will likely keep the hiking cycle gradual, keeping a lid on the USD.
The key feature in jobs today is the type of "tasks" done in them
As we wrote in our previous note, the distinguishing characteristics of a job in the current labor market is not simply the skill level required for it or the industrial sector it is in, but rather, the sort of tasks it requires. In particular, tasks that have a repetitive, "routine" quality are now the most vulnerable to automation and the march of technology, robotics and artificial intelligence." - source Bank of America Merrill Lynch
Obviously, the consequences of such "hysterisis" and "polarization" are that they are clearly contributors to tame aggregate wage pressures despite the low unemployment level reached. Higher-paying jobs might be continuing to grow but what is indeed lacking and which is worrying is the hollowing out of the American Middle-class. The stagnant wages of middle and lower skilled workers have had political consequences and were no doubt one of the driving forces behind the election of president Donald Trump. This is an issue we discussed in January 2017 in our conversation "The Ultimatum game":
"The United States need to resolve the lag in its productivity growth. It isn't only a wage issues to make "America great again". But if Japan is a good illustration for what needs to be done in the United States and therefore avoiding the same pitfalls, then again, it is not the "quantity of jobs" that matters in the United States and as shown in Japan and its fall in productivity, but, the quality of the jobs created. If indeed the new Trump administration wants to make America great again, as we have recently said, they need to ensure Americans are great again." - source Macronomics, January 2017
For now the rhythm in the "Fandango" dance is increasing while some positioning appears to us stretched (US Treasury Notes short base, very long Oil speculative positioning, short US dollar to name a few) making some "convex" trades from a "contrarian" perspective somewhat enticing but, we ramble again...
"Never give a sword to a man who can't dance." - Confucius
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