August 2016

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The Chicago Tribune recently wrote about how the decision to reduce the expected-return assumption from 7.5% to 7.0% for the Illinois Teachers Retirement System resulted in the governor calling for approximately $400 million in additional taxes.

While the political positioning behind this small move of 0.5 percentage point is fascinating, it more importantly brings to the forefront the issue of how large future obligations are, and why there is a lot of fear and an incentive to hide.

If reducing the expected return assumption from 7.5% to 7.0% results in an additional $400 million- 500 million a year of taxes, then moving the liability discount rate to something closer to a risk-free rate of 3% may imply additional $5 billion in additional contributions (Note: the actual number is likely several times higher than this – see the illustration below for some simplified math).

The dilemma we face is that we have made future promises and don’t have enough money set aside today to pay them. Therefore someone has to make up the shortfall. Instead of trying to determine who makes up the shortfall, we try to bury our heads in the actuarial sand of high expected returns.
But where can Illinois get the additional $5 billion a year? And where can America get the additional $6 trillion?

Investment returns aren’t going to help:

The Teachers Retirement System assumes that investment returns over the long-term will average 7%. With liabilities of $108 billion, and assets of $41 billion, even if investments return 7% per annum, the hole will only continue to grow (see Illustration below). This is why using investment-return expectations to discount liabilities isn’t appropriate.
But investments don’t return 7% year-in, year-out. For simplicity, let’s assume the long-term horizon to be 10 years. Even if there is one year where returns are negative-20%, this results in an asset value that is over $20 billion lower (see illustration below).
When risk-free rates were around 6%-7%, generating 8%-10% expected returns required minimal risk and complexity. However, with risk-free rates at 2%-3%, generating even 7% is a lot harder. While investment teams at pension funds such as Teachers are extremely capable, high expected returns are forcing them to take on additional risk, either in the form of increased leverage or complex investments.

The Rockefeller Institute of Government points out that “taxpayers and citizens may or not want this risk taken on their behalf, but they have little say in the matter. And they have no easy way out: If they want pension funds to take less risk, they’ll have to increase government contributions by even more than contributions have gone up already”.

Inflation may not help either.

Arguments in favor of using higher discount rates tend to revolve around the “artificially low” level of interest rates fueled by central-bank actions, and a belief that discount rates would return to a more “normal” level in the future. However, a return to “normal” is likely to be accompanied by an increase in inflation. For public plans, higher inflation could actually be a problem, as benefits tend to be linked to inflation, and therefore liabilities would likely get larger, not smaller, with inflation.

Therefore, by not putting in the money today, we are effectively making a leveraged bet on the stock market, and hoping it pays off, and praying that inflation stays low.

If average returns are only 6%, state funds in aggregate will run out in 2024. That’s only eight years from now.
And if the bet doesn’t work then who will pick up the pieces?

In 2010, Stanford Prof. Josh Rauh estimated that if state pension funds earned an average return of 8% on their assets, then states would in aggregate run out of funds in 2028. If average returns are only 6%, then state funds in aggregate will run out in 2024. That’s only eight years from now.

According to Rauh, funds would need to earn at least 10% per annum out to 2045 in order to sufficiently meet their obligations.

Higher inflation and lower investment returns would only make this situation worse. Current taxpayers and lawmakers are either unwilling or unable to shoulder the burden, as recent events in Illinois have highlighted.

This then shifts the burden to future taxpayers. As this burden becomes more apparent, Rauh speculates that taxpayers may choose to relocate from states with high unfunded pension liabilities. This would, in his opinion, increase the likelihood of a federal taxpayer bailout. Failing that, states would have to resort to what has so far been unthinkable — cutting benefits. In the absence of a federal bailout or a cut in benefits, it’s likely that municipal-bond holders would have to take a hit, as tax dollars get used to fund pension benefits.

Quantifying the true extent of liabilities is the first step in recognizing the magnitude of the problem; the amounts involved are too large to ignore, and it impacts almost everyone. Hopefully policy makers can make informed decisions before its too late.

If decisions aren’t made, then our only hope is that we earn over 10% investment returns each year. Would you take that bet with your future?

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How about that: Among the 14,900 “new” Hillary Clinton emails uncovered by the FBI are 30 or so that concern the Benghazi attack — the most controversial single episode in Clinton’s four years running the State Department.

So much for Clinton’s claim that she’d handed over all her work-related emails. Heck: So much for any remaining illusion that she even tried to provide a complete record.

But, as someone once asked: What difference, at this point, does it make? Can Hillary’s “trust deficit” get any deeper?

In part, that depends on what’s actually in the emails, which may not be released until the end of September.

But it also seems to up the odds that the overall FBI “dump” will have some kind of bombshell. Benghazi’s been a matter of prime public and congressional interest for the last four years. If Clinton wouldn’t even make a good-faith effort to hand over everything on that topic, then she wasn’t trying for full disclosure on any front.

Bigger picture: This is a taste of what a Hillary presidency would bring, just as Bill’s did back in the ’90s — endless low-level scandal, occasionally flaring up into something far larger.

It’s no mystery why. The Clintons just refuse to play by the rules — whether it’s “renting out” the Lincoln Bedroom to big campaign donors in Bill’s White House, or giving preferential access to big Clinton Foundation donors at Hillary’s State Department.

And when they get caught, they never, ever just apologize and come clean. Instead, they circle the wagons and stonewall. Finally they answer the drip, drip, drip of fresh damning details with chants of “Old news” and “Let’s move on.”

It’s how they’ve rolled for four decades in the public eye. At 68 and 70, they’re not going to change. A vote for Hillary is a vote for another tarnished presidency.

You’ve been warned — again.

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One of the sideshows of the Brexit campaign was a debate on the question of whether Margaret Thatcher would have supported Leave or Remain. It was a debate carried on largely by people who either knew her as a parliamentary colleague or worked for her in one arena or another, and it was therefore fairly civilized. It was also inevitably speculative. We can’t know for certain how someone would react to an event after her death; she never saw the EU reform package that David Cameron brought back from Brussels, for instance.

Still, we can make informed and cautious guesses. In my own own take on the story (“Thatcher’s Advisers Argue over Her Likely Position on Brexit”), I concluded that — whatever the uncertainties — Mrs. Thatcher would have voted for Brexit, doubtless after carefully examining both sides, but firmly and with very few doubts.  Now that the Brits both in the referendum and in government policy have adopted Brexit — in effect, now that Mrs. Thatcher has triumphed posthumously — what effect will this have on her reputation? It seems an odd question. How can events three years after her death change people’s judgments on her actions in life?

But it thrusts itself forward because her record on Britain and the European Union is often cited, even by friendly critics, as the largest single blot on an otherwise splendid career of achievement. As for unfriendly critics . . . here is the judgment of Ian Gilmour, a Tory grandee whom she fired from her first Cabinet: Although she signed the Single European Act, under which Britain sensibly pooled much sovereignty with her partners, Thatcher showed a deep-seated prejudice against the European community in all her meetings with ministers and officials, according to an adviser who was present. Nigel Lawson noted her “truculent chauvinism” in Europe, and Campbell considers Europe to have been the greatest failure of her premiership.

The Campbell in question is John Campbell, a pretty fair-minded biographer, whose picture of Thatcher on Europe shows a woman whose “truculent chauvinism” was held in check by the realities of office but who in retirement finally allowed her prejudices to overcome her judgment. She seemingly reached this stage with the publication of her final book, Statecraft, which came up to the very brink of advocating withdrawal from the EU. In his biography, The Iron Lady, Campbell summarizes the arguments in Statecraft as follows: Europe, she had concluded after years of trying was “fundamentally unreformable”. It was “an empire in the making . . . the ultimate bureaucracy”, founded on “humbug”; inherently protectionist, intrinsically corrupt, essentially undemocratic, and dedicated to the destruction of nation states. “It is in fact a classic utopian project, a monument to the vanity of intellectuals, a programme whose inevitable destiny is failure.” That being so, she now called, as she had never done so explicitly before, for a fundamental renegotiation of Britain’s membership, and if that failed — as it was bound to do— for Britain to be ready to leave the union and join the North American Free Trade Area instead, turning its back on the whole disastrous folly.

When Statecraft was serialized in the Times of London in 2003, the reaction of the political and media establishments was sulphurous. Campbell again: This time the consensus was clear, right across the political spectrum, that she had finally lost touch with reality. Her reading of history was denounced as blinkered nonsense; the option of renegotiation was dismissed as fantasy; the idea of withdrawal as simply impractical. In the Commons, Tony Blair challenged Iain Duncan Smith to disown her views. “To talk about withdrawal and rule out the single currency whatever the circumstances is not an act of patriotism. It is an act of folly.”

Duncan Smith refused to disown her, as Campbell points out, but practically every other prominent Tory, respectable person, and important organization did so in extravagant terms — small-minded, xenophobic, Little Englander, etc., etc. It was made clear that Britain’s membership in the EU was an unchangeable reality of Britain’s future, support for it an establishment orthodoxy, and opposition to it an eccentricity at best. Since she was leaving public life on medical advice, she was no longer available to defend her own views.

Only a handful of political allies came to her defence, and they were duly caricatured as the awkward squad, losers, fruitcakes, loonies, and so on. It seemed with the emergence of David Cameron and the self-styled modernizers to lead the Tory party two years later that Euro-skepticism was dead and would shortly be buried along with Mrs. Thatcher when her funeral took place as it did in 2013. It was in the atmosphere of 2013 that obituarists attempting to sum up her career usually concluded that “Europe” was the main issue where she had been wrong-footed by history.

Those who sympathized with her on the question, as I did, tended to argue it was too early for such a confident verdict. We advanced such tentative arguments as she was “either behind history or ahead of her party.” Today it looks as if she was ahead of both. How did that happen? And what conclusions should we draw? One reason is that Mrs. Thatcher always had much more support from the general population on Europe than from the political and other elites. Opinion polls from the 1970s to this year always showed that a large segment of the British population supported the U.K.’s withdrawal from the EU. This support fluctuated, only occasionally becoming a majority, but it never dipped much or for long to below 30 percent.

The Euro-skeptics were treated by the media as a niche minority — which probably depressed their numbers more than fairer coverage might have done. But when the referendum rules forced the media to give Euro-skepticism fairer coverage, the Leave camp became a popular majority in less than four months. And Thatcher was an important symbol for it. That was even truer for the Tory party than for the electorate at large. Euro-skepticism had always been the opinion of most Tories in and out of Parliament. Their leadership, on the other hand, was mainly Europhile. As a result, successive Tory leaders had to conceal from the rank and file their degree of commitment to the “European idea.” Their rhetoric was always more Euro-skeptic than their policies and intentions.

Thatcher had been an exception; it was one reason she had been popular with the party faithful and why the post-Thatcher leadership had either to crush her opposition or to recruit her memory. Now, the referendum stretched Tory loyalty to David Cameron and the Europhile cabinet majority to the breaking point and beyond. Again, she was an obvious symbol — and beneficiary — of this peasants’ revolt. Much the most important reason for the revival of Thatcher’s reputation, however, is that she increasingly proved to be right. Read the list of her criticisms of the European Union listed by Campbell above. Fundamentally unreformable? Check.

All its reforms so far are attempts to consolidate its founding errors. An empire in the making . . . the ultimate bureaucracy? Check. The European Commission, an appointed bureaucracy, enjoys a monopoly power of initiating legislation, and the decisions of the EU’s courts are as binding on national governments as any Viceroy’s. Founded on “humbug”? Well, if humbug means false claims of superior virtue sustained by lies and trickery (such as recycling the European Constitution rejected in referendums as the Lisbon Treaty not subject to one), that’s almost a textbook description. [I]nherently protectionist, intrinsically corrupt, essentially undemocratic? Check, check, check. Dedicated to the destruction of nation states?

That’s actually on the packet along with endorsements from numerous Euro-crats, most recently Jean-Claude Juncker. A classic utopian project, a monument to the vanity of intellectuals, a programme whose inevitable destiny is failure? Well, I suppose one would have to concede that the destiny of the EU is not yet fully worked out. But the Euro and refugee crises — both resulting directly from two of the EU’s fundamental institutions, both embarked upon for largely theoretical reasons, both threatening the welfare of millions of ordinary Europeans, both stretching the loyalty of EU governments to Brussels, both posing existential threats to the EU and indeed to Europe itself, yet both seemingly endless and “unreformable” — certainly have the smell of Utopia and the Faculty Lounge about them.

Both these crises, moreover, arose half a decade after Mrs. Thatcher’s criticisms of the institutions and policies that produced them. In addition to being a shrewd critic of the EU, therefore, she also counts as a highly prescient seer. Compare that record with those of her most trenchant pro-EU critics, notably Tony Blair cited above. Blair not only advocated British membership in the EU’s single currency, the euro, when it was still a proposal, but he continues to argue for it now that it is visibly wreaking havoc across Europe. He also promised to reform the Common Agricultural Policy when he was the revolving EU president, surrendering part of the Thatcher financial rebate to win this “reform,” and he got almost nothing in return: The CAP still gets 40 percent of the EU budget. “Act of folly” does not seem a sufficiently harsh description of such blindly optimistic stupidity and failure.

On Europe, the question today is not ‘Why did she get it right?’ but ‘Why did all of them get it so wrong?’ Disappointed “Remainers” currently comforting themselves that the clever people voted to stay in the EU and that it was mainly “uneducated” people who opted to regain Britain’s independence should perhaps reflect on the relative reputations of Thatcher and Blair today — and on the reputations of Blair’s heirs in the modernizing wing of the Tory Party.

It’s now clear that they got Britain wrong and Thatcher got her country right. What is more important, however, is that she got the EU right, too—indeed, she got Britain right because she got the EU right. She recognized that the pragmatic British would never feel comfortable inside its centralized bureaucratic structures with its over-regulation, grandiose ambitions, and lack of democracy—and that these failings would get worse and more intrusive over time. It got worse and the Brits voted Out. Brexit repairs the largest single hole in her reputation — and tears several holes in the reputations of her rivals in all parties. Today the question is not “Why did she get it right?” but “Why did all of them get it so wrong?”

Postscript: In view of my praise for the arguments of Statecraft, maybe I should make clear that I had no hand at all in its composition. It was written by the team of Mrs. Thatcher, Robin Harris (her longtime adviser and the biographer of Talleyrand as well as of Mrs. T — the yin and yang of diplomacy, you might say), and Nile Gardiner (their researcher and now director of the Thatcher Institute for Liberty at the Heritage Foundation).

My part was solely that Robin and I took Lady Thatcher to lunch in order to persuade her to write it. As we settled down in the restaurant to read the menu, Robin leant toward Lady T and said quietly: “Don’t look up, but Mr. Heath is just two tables down from us.” She waited a moment or two, then leant forward in the former prime minister’s direction, smiled, and waved. He nodded back, and we all turned to ordering, discussing the Statecraft project. Lady T, however, said that we must stop by Ted’s table and say hello to her great rival when we left. We agreed. At the table between Ted and us, within easy earshot of both, were two smart well-dressed ladies of about Lady T’s age minus about five years. They got up to leave while we were still at the coffee stage, walked past our table, paused, and then did that little hesitation waltz that all celebrities must learn to fear. It conveys “should we/shouldn’t we,” and it continued for a moment as the ladies slowly turned pink in the face. Then one stepped forward and said in a pleasant soft Northern English accent: “Lady Thatcher, we apologize for disturbing your lunch, but we’ll do so only for a moment. We just wanted to thank you for saving our country.” “That’s right,” said the other lady. “Before you, we were on the road to ruin.” “How very kind of you,” responded Lady T. “Please join our table for a coffee.” “No,” they replied. “We said we wouldn’t and we won’t. But thank you.” They were as good as their word and left. Lady T said: “Well, wasn’t that nice of them. But we should leave, too. Let’s stop by and say hello to Ted.” Ted too had been finishing his coffee only a moment before. But Ted had gone. After that, it wasn’t hard to persuade Lady T to write Statecraft.

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CHAPEL HILL, N.C. (MarketWatch) — September is an awful month for the U.S. stock market, regardless of how you slice and dice the data.

Since the Dow Jones Industrial Average was created in the late 1890s, September has produced an average loss of 1.1%. The 11 other months of the calendar, in contrast, have produced an average gain of 0.8%.

Furthermore, September’s awful record can’t be traced to just one or two terrible years. On the contrary, the month has an impressively consistent record at or near the bottom of the rankings.

“If a convincing explanation for the September effect were ever found … the historical pattern would quickly disappear.”
Larry Tint, chairman of Quantal International
In fact, as you can see from the accompanying chart, September was a below-average performer in all but one of the dozen decades since the late 1800s. And in more than half of those decades, it was in 11th or 12th place in a ranking of monthly average performance.
Does this terrible track record mean you should “sell in September or get dismembered,” to quote a clever phrase that hedge fund manager Doug Kass recently used in an email to followers?

I’m not so sure.

Awful as September’s record is, bad stats are not, in and of themselves, sufficient reason to make portfolio changes. Correlation is not causation, after all. And, try as I might, I have yet to come across a plausible explanation for September’s record.

And I have tried. Every year around this time, I have asked you to submit your hypotheses for why September should be so awful, and none that has been submitted up until now has been able to withstand statistical scrutiny.

(These are the most popular hypotheses: 1. Investors are more prone to sell stocks when they return from summer vacation; 2. Many mutual funds have fiscal years that end Sept. 30, leading them to engage in “window-dressing” during the month; and 3. Investors are forced to sell equities in September to pay the sky-high tuition bills they’ve just received from their kids’ private schools and colleges.)

Some of you will take this discussion as a challenge to find the “real” explanation for September’s dismal record, but Lawrence Tint advises you not to waste your time. Tint is the former U.S. CEO of Barclays Global Investors and currently chairman of Quantal International, a risk-management firm.

In an interview, Tint told me: “If a convincing explanation for the September effect were ever found, savvy investors would immediately begin jumping the gun by selling in August, others in turn would try to beat them, and the historical pattern would quickly disappear. Unless you or I are able to discover something nobody else knows about, by the time we know why a pattern exists, it’s too late to profit from it.”

In other words, two preconditions must hold in order for it to make sense to bet that September will continue to be awful for stocks. First, the month’s dismal record has to be more than a mere statistical fluke of the historical data. Second, the reason for its terrible performance must remain a mystery.

Good luck with that.

To be sure, there may be other good reasons to avoid the stock market in coming weeks. In fact, I’ve suggested a couple in recent columns — everything from excessive bullish exuberance among market timers to an extremely overvalued stock market.

But note carefully that if you choose to act on those other reasons and build up a cash position in coming sessions, you will be doing so for reasons having nothing to do with the calendar soon to read “September.”

The reason historically was harvest time. Many commodities were sold at this time, thus depressing prices. This would have occurred for a long time. Today, it’s not an issue, but somehow the pattern remained and September is just a bad month for stocks. This can often carryover into October.

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From Bill Gross

I and others however, have for several years now, suggested that the primary problem lies with zero/negative interest rates; that not only do they fail to provide an “easing cushion” should recession come knocking at the door, but they destroy capitalism’s business models — those dependent on a yield curve spread or an interest rate that permits a legitimate return on saving, as opposed to an incentive for spending. They also keep zombie corporations alive and inhibit Schumpeter’s “creative destruction” which many argue is the hallmark of capitalism. Capitalism, almost commonsensically, cannot function well at the zero bound or with a minus sign as a yield. $11 trillion of negative yielding bonds are not assets — they are liabilities. Factor that, Ms. Yellen into your asset price objective. You and your contemporaries have flipped $11 trillion from the left side to the right side of the global balance sheet. In the process, you have deferred long-term pain for the benefit of short-term gain and the hopes that your ancient model renormalizes the economy over the next few years. It likely will not. Japan is the petri dish example for the past 15 years. Other developed market economies since Lehman/2009 are experiencing a similar fungus.

Investors should know that they are treading on thin ice. The problem with Cassandras, such as Gross and Jim Grant and Stanley Druckenmiller, among a host of others, is that we/they can be compared to a broken watch that is right twice a day but wrong for the other 1,438 minutes. But believe me: This watch is ticking because of high global debt and out-of-date monetary/fiscal policies that hurt rather than heal real economies. Sooner rather than later, Yellen’s smooth shot from the fairway will find the deep rough.

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We are currently on the mid-semester break. However, we also have 3 major assignments to complete, which, will negate much, if not all of the break.

Currently I am working on 2 out of the 3: Commercial Transactions and International Environmental Law. Both are 5000 word efforts. The issue isn’t getting to 5000 words, the issue is staying within the word count.

Commercial Transactions is already sitting at 3000 words and I’m not even fully 50% through the assignment. That doesn’t even include footnotes. At the moment I feel somewhat burnt out with it, hence the moan.

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Thirty-six years ago, long before introducing iPhone, iPod or even the Mac, Steve Jobs established Apple’s first operations in Europe. At the time, the company knew that in order to serve customers in Europe, it would need a base there. So, in October 1980, Apple opened a factory in Cork, Ireland with 60 employees.

At the time, Cork was suffering from high unemployment and extremely low economic investment. But Apple’s leaders saw a community rich with talent, and one they believed could accommodate growth if the company was fortunate enough to succeed.

We have operated continuously in Cork ever since, even through periods of uncertainty about our own business, and today we employ nearly 6,000 people across Ireland. The vast majority are still in Cork — including some of the very first employees — now performing a wide variety of functions as part of Apple’s global footprint. Countless multinational companies followed Apple by investing in Cork, and today the local economy is stronger than ever.

Steve Jobs visits Apple’s new facility in Cork, October 1980.

The success which has propelled Apple’s growth in Cork comes from innovative products that delight our customers. It has helped create and sustain more than 1.5 million jobs across Europe — jobs at Apple, jobs for hundreds of thousands of creative app developers who thrive on the App Store, and jobs with manufacturers and other suppliers. Countless small and medium-size companies depend on Apple, and we are proud to support them.

As responsible corporate citizens, we are also proud of our contributions to local economies across Europe, and to communities everywhere. As our business has grown over the years, we have become the largest taxpayer in Ireland, the largest taxpayer in the United States, and the largest taxpayer in the world.

Over the years, we received guidance from Irish tax authorities on how to comply correctly with Irish tax law — the same kind of guidance available to any company doing business there. In Ireland and in every country where we operate, Apple follows the law and we pay all the taxes we owe.

The European Commission has launched an effort to rewrite Apple’s history in Europe, ignore Ireland’s tax laws and upend the international tax system in the process. The opinion issued on August 30th alleges that Ireland gave Apple a special deal on our taxes. This claim has no basis in fact or in law. We never asked for, nor did we receive, any special deals. We now find ourselves in the unusual position of being ordered to retroactively pay additional taxes to a government that says we don’t owe them any more than we’ve already paid.

The Commission’s move is unprecedented and it has serious, wide-reaching implications. It is effectively proposing to replace Irish tax laws with a view of what the Commission thinks the law should have been. This would strike a devastating blow to the sovereignty of EU member states over their own tax matters, and to the principle of certainty of law in Europe. Ireland has said they plan to appeal the Commission’s ruling and Apple will do the same. We are confident that the Commission’s order will be reversed.

At its root, the Commission’s case is not about how much Apple pays in taxes. It is about which government collects the money.

Taxes for multinational companies are complex, yet a fundamental principle is recognized around the world: A company’s profits should be taxed in the country where the value is created. Apple, Ireland and the United States all agree on this principle.

In Apple’s case, nearly all of our research and development takes place in California, so the vast majority of our profits are taxed in the United States. European companies doing business in the U.S. are taxed according to the same principle. But the Commission is now calling to retroactively change those rules.

Beyond the obvious targeting of Apple, the most profound and harmful effect of this ruling will be on investment and job creation in Europe. Using the Commission’s theory, every company in Ireland and across Europe is suddenly at risk of being subjected to taxes under laws that never existed.

Apple has long supported international tax reform with the objectives of simplicity and clarity. We believe these changes should come about through the proper legislative process, in which proposals are discussed among the leaders and citizens of the affected countries. And as with any new laws, they should be applied going forward — not retroactively.

We are committed to Ireland and we plan to continue investing there, growing and serving our customers with the same level of passion and commitment. We firmly believe that the facts and the established legal principles upon which the EU was founded will ultimately prevail.

Tim Cook

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