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On January 10, Litman Gregory's Chad Perbeck, CIMA®, moderated a roundtable discussion and live Q&A session featuring Michael Kass, portfolio manager, Baron Funds; Maria Giraldo, CFA®, Director and Investment Strategist, Guggenheim; and Tushar Yadava, Vice President, iShares Investment Strategist, BlackRock. The panelists shared their market outlook for 2018 and answered questions from attendees.
Here is a replay of the discussion:
Chad Perbeck: Hello everyone and thank you for joining us today. This is Chad Perbeck. I'm a senior research consultant at Litman Gregory. This webcast seeks to leverage our 360 views program, in which we aggregate valuable research content from Litman Gregory's research alliance members centered around a focused theme and then distribute it as a value add to subscribers of our research publishing service. Today's webinar - the format's going to be a virtual panel featuring Michael Kass of Baron Funds, Tushar Yadava of BlackRock and Maria Giraldo of Guggenheim. It's really designed to help attendees gain valuable insight and perspective on what's expected here in 2018.
Now here's just a snapshot of our agenda today. I'm briefly going to introduce each speaker and then pass the mic to them for some prepared remarks. Each speaker will have about ten minutes. The panelists will speak about how they're approaching today's market environment and we'll cover a wide range of interesting and timely topics. Now after each panelist has presented their views. We're going to open up the Go To Webinar control panel for a virtual Q&A session during which attendees will be prompted to submit live questions to the panel. Now if you think of questions as they're each presenting please feel free to submit them at that time and we'll aggregate them here to be addressed at the end, time permitting. Of course, if we get too many questions to cover in our allotted time frame we'll follow up with you after the webinar. Now I would like to introduce our first panelist, Michael Kass joined Baron in 2007 as a portfolio manager and has 31 years of research experience. From 2003 to 2007, Michael was a managing principal of Artemis Advisors, which he formed to acquire the Artemis Funds, a long/short equity strategy he cofounded in 1998. From 1993 to 2003, Michael worked at ING Furman Selz as a director of proprietary trading and was named senior managing director and portfolio manager in 1996. From 1989 to 1993, he worked at Lazard Frere as an associate in investment banking, and from 1987 to 1989, Michael worked at Bear Stearns as a corporate finance analyst. Michael graduated summa cum laude from Tulane University with a B.A. in Economics in 1987.
Welcome Michael thanks for joining us. Please take it away.
Michael: Thanks. All right well thanks for inviting me to speak today.
I think we have a couple of slides that were just you know in the limited time I just wanted to try to focus on the key catalysts and drivers of market performance.
You know looking back the last year or two years in terms of where we've come from and use that as context to make some remarks about you know what maybe lies ahead both in 2018 and beyond. So if we can pull up the first slide.
I manage both the International Growth strategy, as well as the Emerging Markets dedicated strategy. So I'll really speak to all of the non-U.S. markets for the most part. So looking back I’d like to go back to maybe early 2016 which really was the inflection point coming out of what was a pretty protracted period of underperformance for international equity as well as an outright bear market for emerging market equity. That ended somewhere in the first I'd call and if I could pick a spot it would be March/April of 2016. And that was the point of which I would say we saw a return to policy resynchronization in terms of monetary policy in the U.S. The Fed indicating that they would be moderating for the time being there their hiking campaign and in bringing US policy more in line with what we were seeing which was kind of aggressive support in Japan and Europe.
And again right at that point in time there was an important G20 meeting in 2013 in Shanghai where really all global monetary policymakers shifted more aggressively toward a support mode. That was in the face of what was you know a lot of pressure on commodity prices, on economic growth, global trade, trade flows, capital flows.
You recall the U.S. high-yield market was beginning to seize up in January/February 2016. So to me the big important inflection point that we saw happened in March April causing triggering really a reversal of leadership and a bottom in the beginning of an outperforming phase for EM. We saw commodities turning at that moment into 2016, reverse of cyclicals. And so I would say 2016 was more of a reversion period for value and cyclical sectors, for those countries and currencies that were more that had more of a procyclical and more commodity bias. That is certainly as we manage a high-quality growth strategy, that's more of a headwind environment for our particular strategy in a from a relative performance perspective but 2016 was clearly a bottom a good year for international and EM equities. That was punctuated by the somewhat shock of the Trump victory in November as the market was not prepared for that outcome. That triggered an acceleration of a rotation to value/financials. Markets were quickly discounting a higher growth, higher interest rate, higher inflation bias, higher fiscal stimulus slight bias coming out of the U.S., which would obviously have impact globally. And so you saw a real rotation, dollar strength in particular.
You know I would say while it was a reasonably good year for international and EM in ’16 heading up to that moment from that moment to the end of the year there was a very significant sell off in high-quality growth stocks tech stocks, etc., in the fourth quarter of 16 that really set up what we saw last year because heading into last year the market had nearly fully discounted what I would call Trump's provocative campaign proposals during the campaign and they quickly discounted things like border import taxes or a trade war, you know, pulling out of the trade agreements, some form of a new you know aggressive position vis a vis Mexico or Taiwan. And that certainly had a real negative impact. On both international and particularly emerging markets.
I should also just call out at that time, late 2016 and early ’17, there was also India which was a large exposure for us but India you know Modi was implementing something called demonetization that also just had the impact of creating a near term liquidity vacuum in India.
The Indian economy and any real of the performance of Indian stocks were a very brief period of a few months that and again I thought those factors set up a very strong you know that brief period of underperformance set off a huge recovery and a mean reversion back to growth, high-quality growth emerging, the less commodity centric parts of the emerging markets and international markets. Because most of the first half of last year was really about the unwinding of the probability of Trump successfully implementing those proposals. It became very clear that his MO was to shock and awe with provocative opening negotiating positions and then continually walking back and up with some form of compromise that is somewhat business friendly, capital market friendly. Obviously you know healthcare bill not going through with them was then discounted amongst many other areas of his policy proposals that were then including tax reform that by the summer of late summer of last year the probability of those passing went down near zero and that was really the story I think in the first half in the US and globally are the big as it were the large catalysts particularly impacting international while that's playing out obviously we had you know a strong, cyclical, global recovery, acceleration in trade flows, all those things that were weighing on the sectors that I cover or the countries where we invest in the previous years were reversing to the positive.
So you had a big cyclical earnings momentum picking up, beginning to play out throughout 2017. I think a big factor in ’17 with the China Party Congress in November. But more important that was probably the success with which Chinese authorities were able to manage a rebalancing of their economy and a tightening of credit to the speculative financial pockets of their economy. They manage that pretty deftly and I think there were a lot of sceptics that had to begin to rethink their negative bias on China as you moved into the second half of last year. So all things related to China had a very significant appreciation in the second half of ’17. Another big catalyst was the U.S. tax reform which again is viewed as pro growth. Certainly here but also cyclically, globally. And I think it's you know while the earnings impact was here in the US, the stock market impact was global and that synchronized global acceleration continued through the end of the year and on some levels is also continuing into the early into January this year. I think the other points on international particularly developed international over both 2016 and 17 Support for international equities was really in both Japan and Europe. There at an earlier phase of the monetary cycle so there's much more significant monetary liquidity support in those markets.
Ongoing while the Fed is already had now begun to reverse out normalize policy is engaged in a series of rate hikes. We are not yet seeing that in Japan and Europe. Those markets. Japan certainly outperformed global markets or US over the last year or two. There's an acceleration of cyclical and credit act that credit growth in both Japan and Europe which is very healthy for equities. And last I would say there have been political risks in both of those pockets of Europe certainly and in Japan which were essentially put to rest or at least kind of favorably resolved over the last year in the second half of last year. I think all of that led to this. I'd say the third quarter at the end of the third quarter last year in our letter we kind of mentioned this upside overshoot alert that you know we saw how the environment was pretty. There was a rising likelihood of some upside overshoot coming based on all of these factors and I can probably say you know we're seeing that now we saw that developing through the fourth quarter and accelerated here into the very early part of this year. So the next slide is really talking about 2018 and ahead and what we had in our queue. I think there were a couple of important nuances that began to emerge late last year one that the market is kind of not necessarily today picking up discounting. But you know we're very forward looking at the way we think about the environment as the liquidity and risk environment. Just way we're forward looking in terms of identifying investment opportunities and then evaluating our investments in stocks.
But in terms of the broader macro liquidity risk environment you know I think that and entering into this year it's the time to begin to taper enthusiasm I think we reach somewhere in that upside overshoot alert. I don't know how far confidence can carry forward how far this rally right now we're looking at can go. I believe that as we move through this year it will be a year of fundamental strength that is pretty well recognized which will be you know increasing moderation and liquidity and monetary support environment most likely.
We're seeing the confidence you know I'd say the negative of the rising confidence measures we're seeing in recent months and even really the early days of this year. It is an increasing likelihood that the Fed particularly may need to tighten more than what is already been discounted. It will be the first time in seven years that that would happen. So while I believe you know we're likely to remain in a sweet spot for international and emerging market economic growth and earnings progression.
That is fairly well discounted today there is pretty high optimism rising optimism. You know I think the points that the counterpoints in addition to a rising risk of increased tightening is post the China Party Congress there was a series of shifts which I would just interpret as a tightening of regulatory guidance and a tightening up of certain financial tightening in certain pockets of their economy that I'd say particularly with regards to consumer credit where they seem to be pulling back the reins.
They were probably trying to err on the side of support in 2017 leading up to their appointment.
You know once every five year party Congress where they lay out objectives and reset the kind of things, the leadership and the policy they communicated that and now we're seeing some pulling back and normalization of what was very significant support. So those factors caused me to think that once we see that overshoot kind of conclude we're likely to see some rising volatility in the year ahead. More of a broad trading range environment probably a broader range top to bottom than we saw in a normal year. I wouldn't. Last year I wouldn't call it a normal year. The up 30 percent or so in an international 40 percent in EM that we were able to return was really not normal. I think that the trading range and in volatility is going to go back to are going to be a little bit wider than what we will be seeing a little more volatility a consolidation of perhaps at some point this year a more meaningful correction. Longer term however you know I think very much the international and EM outperformance that we're seeing you know maybe well maybe in the early innings I say that because we believe we see widespread favorable shifts in the political orientation in many of my markets relative to what we see in the U.S. with attractive reform agendas in all these countries Japan, India, China, Brazil, Argentina, Chile, France, South Africa. We think there's room for the Europeans discounts to narrow to the extent that some of the political risks continue to be you know kind of addressed and resolved.
There was always some risk that there's an election coming up in Italy you know we're going to be carefully watching that in March. We think that hard Brexit is now becoming much less likely if that's the case the U.K. The pound and the UK equity market. Probably had lagged the rest of the world and will probably have a large part of an international index well into the double digit percent of the index maybe 15 percent and that that can be a source of performance. We think that a lot of the good news in the U.S. while it’s good. It's fairly well discounted. The impact of tax reform is on its way to being discounted we think that the US is more advanced in its economic and monetary cycle. And you know corporations are already coming off the peak of operating margins. So you know we for all these reasons. The risk of the populist shift continuing to take hold in this country to us represent some risk due to excess earnings, excess margins today, or about above normalized margins in the U.S. So there's some risk to corporate margins and some risk to the owners of capital in the US based on this current trend towards the populist direction essentially. I guess what I'm saying is there may be some mean reversion back toward labor towards the middle and lower classes on the income side where that that would be at the expense of corporate profits.
And then last I think one of the big factors in that is that we're looking at is the potential impact that China has nowm for manym many years they focused on gaining global share in low value, high labor intensive high capital intensive industries and they kind of became dominant in a number of those industries worldwide.
Where they kind of are the marginal driver of growth and pricing. They are now turning their emphasis on high value added intellectual capital they industry, areas like technology healthcare bio sciences. You know we think that could have very significant implications over the next five to 10 years in terms of profit share where the developed world companies have targeted China as a big driver of growth in earnings. And that's just going to get on the margin a little more difficult, doesn't mean it won't be attractive for those stories, those companies that are you looking at EM as an opportunity but the next 10 years is probably going to be a slower rate of earnings growth as they have to suffer some loss of market share and pricing power. That will be to the benefit of companies that are operating on the ground in both China and other emerging markets. We see this as this is a phenomenon is going to spread to India and other places, some of the large EM jurisdictions and that's an opportunity for local companies as well as international companies. I would just say that the U.S. has less of a presence on the ground than corporates related to you know other countries such as Japan, some European, France, I mean it's some very active participation and in the EM the large the U.S. economy is a little more insulated kind of on their own.
So for all those reasons we see the next 5 10 years potentially being different and where international and EM can perform there will still be a correlation with things like global liquidity, global growth, the dollar, commodities, etc. But there's probably room for stronger than what has been the historical performance in a downturn in a rising dollar environment and a weaker economic environment and certainly opportunity for we think you know ongoing significant outperformance in the upturn.
And we think we may be heading into a pause which will then hopefully give way to the next leg of an upturn perhaps in 19 or 20. So I'll cut it off there are probably longer than I was supposed to. Sorry about that.
Now I look forward to your questions.
Chad Perbeck: Thank you very much.
I think you did an excellent job of painting a good picture of where we've been in ’16 and ’17 and developed international and foreign markets and setting up a great outlook of where we think we're going and you know just speaking as an individual shareholder in the emerging fund as opposed from the Litman Gregory side of the house. I was a little disappointed that I shouldn't expect 40 per cent again this year but I appreciate you tempering my expectations, and we've had some questions come in when you were presenting about impacts of currency, notably the dollar, on foreign markets and we can get to those during the Q&A so appreciate it again and now we'll just move on and introduce our second panelist: Maria Giraldo is a director and investment strategist and the global chief investment officer, Research Group, at Guggenheim.
She's a key author of some of the firm's leading publications including The Core Conundrum and the quarterly high yield and bank loan report. Her responsibilities include identifying emerging trends across various sectors and analyzing their impact on investment opportunities. And today Maria shares some of those findings with us.
Maria: Thank you. This is a really challenging environment for investment managers we're sort of late in the cycle at this point getting a late boost from fiscal policy in the form of tax reform, which makes you want to extend your view of how long this cycle will last and it's hard to resist that urge when markets are clearly discounting a positive outlook for earnings and economic growth.
At Guggenheim we're hesitant to do just that, to extend our cycle view, because there's plenty of signs of aging that haven't quite disappeared as a result of this new tax bill. Key among those is the vulnerability we see in the economy. That is the result of how much leverage there already is in the system.
So getting to the punch line right up front. We think there is the possibility of a recession occurring in late 2019 or 2020. Now obviously the timing of a recession is an extremely difficult task and I don't think there is any indicator that has been a consistently good one to help you get recession timing right on the nose. So all we can really do is have a view on where those risks are and avoid them.
Now I know this is a 2018 outlook not 2019 or 2020 but what we're doing here is really just taking actions this year, now in 2018, in light of our view. So I'm going to talk a little bit about that.
You know diving right into the slide here like I said earlier it's a challenging environment because there are healthy signs of activity in the economy. Obviously, we saw a rebound in GDP growth in 2017.
Part of that rebound was a result of a rise in private non-residential fixed investment, which is the GDP line item that represents a business investment. And you can see here in purple we're showing here the year over year growth. We saw a decent rebound last year and there was the strength in business optimism that translated into plans for more capital expenditures. So that's the blue line that you're seeing here—the survey reading of small businesses planning to spend more on equipment and a driving. These plans were already rising not just for cyclical reasons which you can see here, it's been rising steadily since the trough in 2008 but also we saw a surge in its survey post election. So businesses clearly thought a tax cut would aid their spending plans and we do believe that under the new tax regime which allows for immediate capital expensing, it will drive additional business investment. The NFIB small business survey’s showing this and also we've seen announcements already made by different companies: Boeing announcing 300 million in investments. Comcast announcing 50 billion over the next five years in infrastructure. Here's our concern: how much more can businesses spend on capex. Our concern really goes back to this vulnerability and that is that there is already quite a bit of leverage in the economy. The ratio of corporate liabilities to GDP is at historical highs even if you net out cash. The investment grade market probably has some capacity to spend more but they risk their own credit rating the more debt they raise and we already have triple B, that's the lowest investment grade rating before high yield, representing the most they ever have of the investment-grade market.
Obviously I'm assuming here that capex will be funded through more debt issuance. Some believe that capex could be funded under the cash repatriation but not only does that represent limited capacity. There's only so much cash that can be repatriated. But most of the cash is held by a very few companies. So all in all yes we do think that we'll get some boost to cap ex this year. And we do think that the tax reform is going to boost GDP probably something to the tune of about 25 to 50 basis points this year. But we're not seeing a significant amount of CapEx spending really beyond that because corporate leverage is already a significant burden and it's probably going to act as sort of handcuffs to significantly more business investment.
So if you move onto the next slide please.
Now the main reason that we really think that leverage makes the economy so vulnerable is because the Fed is tightening monetary policy and raising interest rates and normalizing the balance sheet. The Fed funds is now at one and a quarter to one and a half percent. And U.S. unemployment rate continues to decline. It's now at 4.1 percent. We think it's going to go lower moving toward and possibly hitting 3.5 percent this year. So with the unemployment rate already at 17 year lows there's very little slack left in the economy and there are going to be consequences to that. One of those consequences is that small businesses are increasingly reporting that their biggest problem is a lack of qualified workers. That's the survey line here you see in purple. Historically, as more and more businesses complain about this lack of qualified workers, what they've done to address the problem is offer more money to attract better talent.
So if you look at the Blue Line which is median wage growth that's tracked by the Atlanta Fed they tend to be strongly correlated to each other with a lag. So that whatever the survey was telling us nine months ago is strongly related to where wage growth is today. Now according to one of the economists on her own team here Guggenheim based on the most recent survey wage growth should accelerate to almost 5 percent in nine months time. We'll have a declining unemployment rate, rising wage growth, and we believe we're going to see a rebound in inflation due primarily through base to base effects. Core PCE should move towards the Fed 2 percent target. And we're already seeing a rise in inflation expectations. If we look at breakeven rates. So I think the market is on the same page really about inflation. But what that means is we're going to get. We think we're going to get four rate hikes out of the Fed this year. That you know there's very little stopping the Fed from pushing forward at this stage. And generally there is a sensitivity of borrowing costs to a change in short term rates essentially a positive correlation. So as the Fed raising borrowing costs we believe companies will see rising interest expense as a result of tighter monetary policy. And unfortunately with the new cap on net interest deductibility where companies can only deduct 30 percent of EBITDA of that interest expense some of that interest expense will become nondeductible for tax purposes. And it's going to hurt after tax cash flow for many laggard borrowers mostly in the high market.
So you know for 2018 recapping expect four rate hikes out of the Fed not going to have unintended consequences in the corporate market because of how levered borrowers are.
Here's my last slide please.
I don't mean to sound really sour on the economy. Like I said there are positive signs of healthy activity but we have to remain cognizant of those vulnerabilities. We have an economist on our team here Matt Bush who put together what we call internally a recession dashboard. It includes six leading indicators that exhibit consistent cyclical behavior ahead of a recession. He compares this against the last five or seven recessions I believe they can be tracked in real time. We actually recently published a report on this and it's accessible to everyone if you'd like to read it. Those indicators are the yield curve of course, the unemployment gap, the stance of Fed policy whether they are too loose or too tight, leading economic indicators index, aggregate weekly hours worked, and consumer spending. Now in addition to creating that dashboard Matt Bush put together a recession probability model which is what you're seeing here and that includes many of those same indicators and he developed forward estimates for the indicators that we can see what the probability of a recession will look like over the next two years. Right now the probability of a recession is not high at all. Less than 10 percent over the next six months and 12 months at 20 percent over the next 24 months. Based on his estimate of where the indicators are going to go indicators that comprise this recession probability model we can see that by 2019 that probability of a U.S. recession will grow significantly if the indicators unfold as expected. The chief among those is going to be the yield curve If we're right about the Fed raising interest rates four times this year.
That's going to put us at two and a quarter to two and a half percent by the end of the year. So we're expecting we're going to be pretty close if not at a flat yield curve by the beginning of 2019 and that's generally a signal of a recession within the next 12 months. So to conclude my remarks I'll talk a little bit about what we're doing from an asset allocation perspective specifically in the fixed income markets.
You know what are we doing as we're seeing near term strength. We do see strengthening economy in 2018 but medium term weakness if we're looking at 2019/2020. Our CIO likes to say that large fixed income portfolios changing the direction of them is like changing the direction of a very large ship.
You do it in gradual sort of small degree changes. What we've been doing is aggressively upgrading the quality of our portfolio. In our multi credit per for example we've reduced our allocation to below investment grade bank loans and high-yield bonds previously represented almost a third of our portfolio and now it's down to 5 percent. We just don't see investors getting properly compensated in these markets even if we're wrong about a recession in two years let's say it's three or four years. You're still within the average life of a high yield portfolio and you're just getting about five and a half/6 percent yield on an average high-yield portfolio. We lost just that yield based on typical default and recovery rates during a downturn. You're barely getting compensated more than investing in a Treasury today. We're also seeing signs of excesses in these markets in the loan market. In addition to weak or no covenants which we've seen for years now.
Borrowers are now eliminating LIBOR floors as they were previously around 1 percent. So if LIBOR fell below 1 percent as it has been for most of the cycle there was something embedded in the loan contract that provided a cushion allowing loan investors to get paid a spread over the LIBOR floor about 1 percent or LIBOR whichever was higher. Now the loan market is losing that protection. If the Fed cut rates again anytime in the next five to seven years which is the average life of a loan. Just feels like the sort of late cycle behavior you want to watch out for. And what we're doing instead we're going up in quality limiting loan to value focusing on sustainable cash generating businesses over growth businesses. We do like whole business asset backed securities as a way of participating in the corporate market earn a liquidity premium.
And many of the borrowers in ABS are also borrowers in corporate credit. So we see borrowers like Dunkin Donuts, Miramax. These are borrowers many investors are already familiar with but the structured credit market itself is less familiar so we are a little bit of a premium to participate in it. We also like CLOs mostly triple A double A floating rate that can still participate in the Fed raising interest rates. Give me a little bit of a yield boost. But we like the ones that have been recently refinanced mostly because they'll have a slightly longer call protection and shorter reinvestment periods than if you are participating in a newly issued triple A tranche that is going to reinvest for five years. We'd been participating also in some agency markets, agency CMBS in particular, because you can get yields there that are comparable to investment grade corporate credit, similar duration profile, but now you're in a government backed market so your credit risk is lower. So those are some of the things that were doing in the fixed-income market in light of our views given that we're sort of in this limbo environment for us based on our recession timing. And with that I'll go ahead and hand it back to the host.
Chad Perbeck: Thank you very much Maria. I really appreciate how you tied together what's happening in the current environment here in the U.S. from your point of view, you know high leverage in the corporate market and the recession indicators not flashing red currently but looking kind of shaky getting into 2019, and then tying that together with your portfolio positioning and what you are doing about it with high yield spreads tightening and valuations looking really rich you know tightening the ship down from 33 percent to 5 percent in those markets and looking in structured markets and agency notes things like that. That's really helpful. I think we'll come back to a lot of that and it's nice to contrast that with Michael's kind of international and emerging equities outlook with your domestic fixed income outlook. Now we'll just move on to our third and final panelist Tushar Yadava is a vice president and investment strategist in the iShares U.S. investment strategy group, which is part of their global investment strategies and insight or ISI Group. Global ISI delivers macro and market insight leveraging BlackRock’s thought leadership platforms to provide iShares clients with executable investment ideas using iShares ETFs. Most recently Tushar was a founding member of the iShares Americas capital markets research and content team. His responsibilities there included the assimilation and condensation of sell side macro research and strategy into iShares relevant content as well as the origination of iShares specific content for both internal and external distribution. Tushar worked across the BlackRock and iShares platforms to deliver iShares specific solutions to investors. Mr Yadava service with the firm dates back to 2006 including his years with Barclays Global Investors which merged with BlackRock in 2009. Mr. Yadava earned a B.S. with honors in economics and management in 2003 and a M.A with merit in European Business in 2004. Both from the Royal Holloway at the University of London. Welcome Tushar thanks for joining us.
Tushar: Thanks for letting me on guys, let's go ahead and get that handsome man off the screen stop the pulses racing so I can get on with the presentation. Look one of the joys of going last in one of these things I'm sort of doing the global outlook is I might tread over some of the things that have already been said. Or try and sort of contrast a little bit different. I'll try and stick to the time. The other joy of going last is I want to make sure there’s time for questions for everyone and what I'll do is hopefully you know try and say something controversial enough that you can bring it up in questions and answers. One of the first things that struck me about the presentations before me is well we're going to differ a little bit in terms of our time horizon and I think. Maria did a great presentation talking about you know the view for 2020 mean having 2020 Vision, I’ll bill you for that marketing slogan there it’s perfect. But we’re trying to focus on the next six and 12 month outlook.
So what I’ll try to concentrate on is what we see for this year and the themes that we see for this year and how we see positioning for it and what you'll see and we'll come back to it you know I'll reference back to that when we look at our asset allocation across the BlackRock views and that's on the next slide is we're broadly positive on equities, negative to neutral on different parts of the fixed-income space, neutral on the US, and you know this isn't if anything should be shocking at this point in time. I think throughout this expansion you've been compensated for being in equities appropriately and we will come back to this idea of taking a risk where you're being rewarded adequately for it because that forms where we're seeing these overweights and underweights those green and blue and the gray neutral dashes there. So moving on to the overall outlook for us one of the things I want to sort of immediately impress upon you is that you know while there are risks and you know signs of leverage building and risk you know globally developing bubbling undercurrents, at the moment we still see the global expansion has room to run.
And what I think is important about this is when look coming to 2018. What you'll see is that we had a very sort of downbeat view of 2017 itself and I think what started to happen as we came through 2017 BlackRock was one of the first few people looking at the global economy surprising to the upside is that you started to see these upgrades come through as the year went by and I'll touch them where few of them came off from. But I think it is important going into 2018 is that we're now starting to see those growth surprises that that chart on the upper left hand side is looking at that level off at the higher level and maybe some of sort of you know growth as a whole move sideways. I think the IMF forecast a surprise to the upside for the first time in two years or probably something that's off the sort of level of high at this higher level at least at the top of the cycle which is kind of where I think everyone agrees that we are. You also saw what was discounted into or out of markets in 2017 is largely going to be gone now getting into 2018 I think entering the year and Mike did a great job talking about some of the political outlook as well. What you saw was politics in Europe was very prevalent, the aftermath of Brexit, in the US elections that are coming through, a lot was discounted in the markets.
I think that the shock at least or the over sort of cautious risk approach has maybe been discounted out and that's started to seep through. What's important to sort of understand from that now and you know we're looking largely at the surprise chart here in front of you in different ways or shapes or forms is that the comps become harder to beat as you go through that period of time. Well what I mean by that is that you know once you surprise to the upside you continue a pace of surprise when you find that they come you know just the comparative sort of break the year over year effect starts to slow you down to the level of expectations. And that plus this idea of central banking normalization is going to be something that sort of helps to put a bit of a brake on this rapid acceleration we saw to the back end of last year. So what's interesting to know and I know that much so about as well is that you're expected to continue to see this normalization with the Bank of Japan announcement overnight all the early in the week sort of hinted at that; we expect the ECB continued to sort of move towards tightening that policy closer to the end of the year. And you have as Maria and Michael have said we all expect the Fed will probably continue to deliver on that dot plot. And so what lies in front of us is this idea that while we do have room to run in the expansion we also have expecting a lot of already and a lot of is already priced in. One other break, you know I’ll just on the slides in front of you is sort of our expectations that the blue lines on the chart where we're actually projecting a lot of the things that come in and the green lines where we see the market consensus at the moment. So as you see we're starting to sort of gravitate a little bit closer and the growth surprise that top charts there starting to sort of see that the market catch up to where we were on the inflation surprise level and all of these are freely googleable on our webiste. I encourage you to go around there and have a little poke around. There's always a little bit of fun in nowcasting for the economists out there. The other break that I was sort of alluding to earlier is this idea that we do expect inflation will return in some shape or form. Now the trigger itself for that inflationary surprise is increasingly hard to pinpoint right. You might have heard last year a lot of people talk about this concept of the Phillips curve or the tradeoff between slack and paying more for the additional unit of labor or capital. I think we're in touch with that as well when we're starting to see that that level really be tested in the long run but we do expect that there is still a relationship at play here and you know essentially when you continue to run the economy at this hot enough level you do see a pop and that is something that we forecast I know you know a lot of focus is being placed on breakevens at the moment.
I mean it's obviously interesting when oil was I think something like 50 per cent over the last year to continue to monitor it that but from a core point of view we do continue to see that there will be some wage effects translating into higher inflation as well as you know just continue to this capacity beginning to get constrained in the hot economy. So overall this is enough to tell you that we've had a nice ambient backdrop of growth surprising to the upside and inflation fairly benign. What do you get as a result of that well you get a very predictable response in risk markets right. And I think you know ignore the giant bitcoin bar to the right there but would you start to see that risk assets sort of return in line with what you'd expect. As growth is coming in strong and surprising to the upside areas where you're taking more risks you're seeing higher returns for you. And when we stack them up and look at them over the course of the year that was definitely the case that we saw. What we think is a growing trend looking into 2018 is that you know you're going to need to continue to take risks in areas where you adequately compensated for it. Oh very briefly talk to you on the equity side in that you know earnings comps are harder to beat when you have those higher years and you bounce off a base effect. A lot of it had come from the energy sector. This is not this is not a problem, but expectations are already very, very high in these markets, valuations are already quite high, and a lot of it has already been priced in.
So the areas where we're seeing and we saw last year some of the figures we're continuing see this year in terms of forward valuations like emerging markets, like Japan, their forward valuations actually contracted over the last year, give you a good sense of areas where we like. And if you think back to that slide we like everywhere outside of the US in the equity market specifically emerging markets, specifically Japan. Part of the reason for that is that they're continuing to show that earnings growth and they're doing it at a much more reasonable starting valuation. So the other reason we like those areas is because they're still sensitive to growth as long as that growth is continuing to go forward and driving those earnings per share beats and driving those sort of the ROE improvements which you've been seeing in those areas. We feel pretty confident about being in those equity markets over periods of time when you contrast it to maybe areas like the US where you had a very positive year you had a great surprise for the end of the year. A lot of the beats or a lot of the benefits start to be coming in from areas that aren't exactly organic and I think lot was talked about tax reform I'll come back to that but those are the EPS beats and you know that's the growth in earnings. It's something that we're on the watch for as well. One of the other things that you all point to the sense of starting to wrap here is the idea that when your return is high and your risk is low you feel very confident about a lot of the areas in your portfolio.
Now we look at volatility and this sort of chart just shows you where the annualized volatility was over the last year and it was very, very low across the board and you know you're starting to see maybe upticks in the VIX which is common watched for it. We spent a lot of last year studying volatility and very, very honestly we don't think it's a mean reverting concept, mathematically it's not a mean reverting concept. So when we people say just because the vol is low you should be fearful because it can spike high. We don't think that's a trope that really is very true but what we do think that volatility is sensitive to economic risk and when economic risk changes your return profile is also going to change. So this idea of being very, very comfortable by the risk adjusted returns is something that's incredibly relative as that starts to shift. And you know again we're not talking about 2020, not looking that far ahead, but in general that is something that you would start thinking about at the moment. You're still being quite adequately compensated for taking risks in the right areas. There's certain areas, specifically in the fixed-income markets, where you're not and we think that it doesn't make sense to be riding that until the very last moment possible. You might as well be taking that risk in the appropriate areas at the moment. So one of the last areas I'll focus on the indices the U.S. and you know I think we've already sort of shed a lot of blood in terms of talking about the U.S. economy and U.S. stocks.
But you know I'm a strategist and it's our job to talk over each other and everyone's got an opinion in mind just as right as everyone else. The reason that you know what we're focused on is that it does give you an idea where we see some of the risks forming going forward and where we think that some of the big markets sort of risk on sentiment is really primed to being more vulnerable. So on the economy side obviously you know it is still very, very stable, I think that point was made by Maria before me leading indicators do look very, very positive over a three to six month period. But there are areas where we would sort of look and say hang on a minute, there are certain signs that would give us pause to see if they were baffle-tested as we would imagine. The hiring intentions of the graphics on that were shown in the previous chart that translate into wage gains I think is a very, very pertinent question especially because you know you've just seen this big boost come through the corporations and that lower level which are primary hires where you're seeing some of that wage tightness. The other area is you know credit availability, it’ss a very strong leading indicator especially in corporate space. And that's one area where we're seeing conditions increasingly easier and easier. But demand has been pretty, pretty weak if not negative over that period of time. So we look at it and we say well you know financial conditions are quite easy that underpins a lot of that's something with were start making a little bit more tighter overall, would itself sort of removing some of that feeling of euphoria or easiness in the credit markets and the economy overall. The other area obviously is the Fed. We understand that they are watching this very, very closely.
They do say that they operate on long and variable lags and then tend to really only focus on the immediate and you know be very, very focused on financial conditions overall which is an immediate market pricing indicator that the need for stimulus in this kind of hot economy at the Fed is something they talked a lot about. And you know at their level they don't find very much need for a run policy that obviously helps to balance some of the effect of that, that leans net hawkish. We'll see how that plays out over the year. And obviously one of the great sort of tailwinds for the economy over the last year was very much a headwind in prior years which was the dollar and was low rates. So we're starting to see this area now where rates may maybe backing up a little bit higher and the dollar is you know with a very, very sort of bouncing off a very, very low level in the short term. These are areas that could in fact inflict some pain. Not to mention oil overall where the oil markets have been this incredible so there's a supportive backdrop for the U.S. consumer. In the meanwhile we've made the political powder keg in the Middle East. It is something that does bear watching for implications for the U.S. economy. Very lastly, I'll just point on stocks right which you know are coming in the U.S. from a very, very high level in multiple times earnings growth is continuing to run the club I think we were you know projecting for about $130 on the S&P 500 last year we're going to achieve somewhere in the low $120s that underclubbing has been going on for years.
A lot of it is based on energy gains, a big component of where we see that growth in Q4 earnings that's about to start this week. And a lot of buybacks and dividends are areas where we do look at it and say here's one area where we think the benefits of tax reform might be realized. Corporations always had very, very easy access to cash very, very high profit margins you know CapEx wasn't dependent on that before changing tax reform. Repatriating cash isn't exactly going to suddenly change that dynamic of look for stocks. Stock buybacks and dividends to give you an additional boost in your stock portfolios. I'll wrap by sort of saying look the momentum stocks do very, very well in this kind of environment. We’re very, very positive momentum but as ballast, value is something that we think you know when we look at it from construction often offers a very strong complement to high momentum stocks in this stage of the economic cycle. And we think that value/momentum barbell approach is probably the right approach for looking at stocks in 2018. So with that I'll wrap and hand it back just giving us time for the Q&A there. And hopefully I said something controversial enough if not between the panelists.
Chad Perbeck: Excellent. Thank you very much to Tushar great outline there of the evolving and changing risk reward relationship across global assets.
I know you mentioned the bio photo. I noticed the heart rate monitor on my Fitbit increasing with the accent as well so it's a great combination. Now. Yeah. So now that all the panelists have presented their views I'd like to allow the audience to pose questions for our panelists.
I think we can just go ahead and unmute all three of you and encourage the audience to type your questions into the Go to Webinar interface and we'd be happy to address them here. I know several of you have written in asking about a replay being available and the presentation slides. And yes we will make that available once everything has been compliance approved. So that'll be in your email and on AdvisorIntelligence.com. Moving on to the questions maybe we could go in the order start with Michael again. The order we presented and because this one maybe you would mention that we got this earlier when you were presenting Michael. Just please share your view on currencies and really the U.S. dollar outlook specifically how that's going to impact your investment thesis in 2018 and beyond.
And really a lot of people have been asking you know is it necessary for a decline in U.S. dollar for dollar based investors to get outperformance in developed international and emerging market stocks.
Michael: Okay that last question I would say no there's plenty of periods.
You know through recent and longer term history where you know you can have you can have commodity prices rising with that with a firm dollar you can have internationally and EM equities outperforming and a stronger dollar environment that's often a function as I think as Tushar was just talking about how you know if the economic momentum remains you know pretty solid that that is the larger you know you got lower valuations and stronger and stronger earnings growth in those parts of the world. And so you can have a a correlation. You can have a relationship that's sort of untraditional in terms of the performance of those asset classes versus say a dollar. That's not to say that we have a view particularly right now you know where the dollar is headed I'm seeing you know, there's a lot of controversy around that. So I mean the first thing I'd like to say is international/EM equities could outperform in a firm or even strong dollar environment. But then the question is you know certainly it's a tailwind if you have a weaker dollar environment which is an environment we started seeing in the last in recent weeks as essentially as you're seeing energy/commodity prices get a resurgence of the acceleration here in the last few weeks month.
And I think you know perhaps it is my view and I think some one it both the other panelists kind of I think alluded to this.
I think we're likely to reach a point in the near future where the markets are trying to show the Fed that they're behind the curve on some level and that they're going to have to up their game. They're going to have to increase expectations perhaps of you know perhaps an incremental tightening this year etc. And I think the weaker dollar is partially a mechanism that the market is calling out to try to force that to happen.
And you know that is kind of that that doesn't and that certainly can be happening independent of what's going on economically and from the earnings outlook in the non U.S. markets that can be operating totally independent of that which I think is what's happening now.
I think if you get to a point where the Fed essentially you know foreshadows that they believe they're behind the curve and that there is a fairly significant amount of incremental tightening is going to have to happen. I think when that happens when the market digests that then we're at risk of a more traditional correlation where you have an international that could begin to look a lot more. It looks like they're heading into a correction consolidate consolidation perhaps correction could underperform the U.S. during that period of time. But I think it would be by less than is historically you know less than would be expected and less than we've seen historically for all those reasons that I think we are likely have entered a longer term more protracted period of non U.S. performance outperforming US. But it just means that it'll do it'll underperform by less in the more difficult environment and to outperform by more than expected in the positive environment. But at some point this year I think we will head into that consolidation.
Chad Perbeck: Okay great. Thank you for those comments, Michael. Maria do you have anything to share from Guggenheim’s point of view on currencies to hedge to not to hedge or are you really just focused on U.S. fixed income.
Maria: Well my focus is primarily on U.S. fixed income.
We do have our general view on the dollar being more moderately bullish on the dollar. Mainly we have an internal model that has uses two year swap rate differentials relative price levels and U.S. fiscal and current account the current account deficit projects trade weighted dollar. So you know based on this we're really looking at probably a moderate three point five percent upside or so for the dollar on a trade weighted basis.
In 2018 and then even further out we do think another 5 percent peaking in that growth in 2019 probably by the middle of the year. And then that appreciation is mainly a reflection of rising rates here in the U.S. relative to other economies especially as the Fed is raising interest rates about 4 times. I don't think you know I think given our sort of moderate view on the strength of the dollar we're not looking at the sort of the 2015 type environment significance in 2014/2015 I believe significant strength in the U.S. dollar which put pressure on multinational companies causing a downturn in earnings and obviously there were other factors commodity markets that we had in the oil market also caused energy companies to take a hit in earnings then. But we also did see a drag from the U.S. from the strengthening U.S. dollar and I don't think companies will be quite as sensitive with any strengthening in 2018 or 2019 particularly given our view that it's somewhat moderate.
Chad Perbeck: OK great. Thank you for sharing that Maria. On to Tushar do you have anything on currencies in general the dollar to share or if not to have definitely another question if you want to move on.
Tushar: I mean very quickly I can just say look I mean everyone suspected it was a very long time which we won't even encourage a lot of all sort of investors to take the approach of currencies are mean-reverting game right, the sum of all the economic activity in one region and that affects the rate across those two sort of the terms of trade between those two countries. And I think when people think a lot about this they’re shocked by what happened in 2014 and you know some of the scars still haven't healed; a lot of these were naturally thinking that if that happened in 2014 and ’15. The reverse is obviously true to happen at any point soon. It isn't that simple of a game. I think the dollar everyone will tell you. We think it's probably headed higher just in terms of fundamental valuations in terms of trade on a trade weighted basis in purchasing power parity and interest rate differentials. All these suggest the dollar should be higher against the majors but positioning momentum is probably one of the biggest sort of drivers at the moment. And that hasn't really played out it a lot of people had expected. I think what I would say in terms of general rules that we follow in the very, very short term, emerging markets and you are definitely don’t want to speak over the expert, but what I would say is that when we tend to find emerging market currencies doing well all the assets in that country do well the currencies the unit of risk of that country that very simply.
So we don't really take a view to hedge in emerging markets unless you want to reduce volatility and your expected return should be the same but the outcome is really sort of the risk that you're putting on the table emerging markets. And in developed markets, look at the sort of beggar thy neighbor culture that has been developed is a pretty strong incentive for hedging the currency in the short term but a lot of that is easily communicated through the central bank and I think we're not seeing those divergencies occur that happened maybe in the past that would cause you to sort of run out and think about hedging on a very, very short term basis.
But when you think about it from your equity returns some of those some of those equity markets if your dollar based investor do really, really well when the currency is weakening. But we're not in that kind of low growth environment where we need that at the moment. So I wouldn't sort of sit there and say yes run out and think about hedging at the moment.
Chad Perbeck: Okay great thanks Tushar for covering that to hedge or not to hedge. I know we're running up against time I had one specific question for Maria and then I'd like to give everybody as you know just a couple more minutes. One final question that we got to all the panelists. Maria specifically the question was how would you expect your recession forecast that you showed to impact the CLO market if it were come to fruition.
Maria: That's a great question. You know the CLO market is one that we in our in our research are due diligence have found that you know they've improved kind of structures.
You know it generally they have somewhat better leverage or safer leverage metrics and better protections, triggers that divert cash flows to the higher part of the capital structure and that's part of the reason why we prefer to focus on for the Triple A, double A. We have an analysis that we call it Groundhog Day that Groundhog Day analysis defaults the loans in the underlying CLO portfolios at a rate that's consistent with what we saw during the Great Depression. And it does that continuously for I believe several years. And what we do is we try to figure out OK if we see this sort of default environment unfold in the in the loan market and the underlying assets of the CLOs is this going to hit obviously it wipe out the equity is it going to hit the you know the single Bs the double Bs the Triple B CLO tranches.
Well we found so far is that generally the triple As and the double As would survive this internal analysis that we have. Once you start to get much lower. The single As triple Bs these are really looking at especially the double Bs really looking at an environment where if the loan environment enters a default cycle similar to past recessions in 2020/2021 those are the tranches that would not survive but would see some sort of principal impact. So you know I would say the CLO AAAs/AAs the have already shown to be resilient in the past cycle. S&P has this figure. I haven't done this analysis myself to be honest but S&P has a figure and they say the Triple A CLOs have never defaulted. Including in 2008/2009 and that was with weaker structures. So our view is that you know the higher in the capital structure will be fine. They'll have sufficient protections in place for you to get paid your money back.
You'll probably see some hit to the market value of those tranches.
So marking to market you're probably going to see some losses but kind of holding it through the downturn I mean that's part of the liquidity issues with the CLO market, holding it through that downturn. We believe that you should be fundamentally fine and you'll get your money back.
Chad Perbeck: Great. Appreciate you sharing that. Thank you Maria. I know we're really running out of time. I appreciate this. One final question here maybe for each of our panelists. Again we could just go in the order that we presented starting with Michael. This is a question that we've been getting a lot and it's on a lot of people's minds and if not specifically for 2018 maybe looking ahead.
You know we've been nine years now into this bull market we're at all this fiscal stimulus is being implemented as well. Many people on the panel and other people have been representing that the Fed is going to hike maybe four times this year. Will all of this lead to us starting to see inflationary pressures in 2018 or do you think that's further out.
Michael: Well I guess I get the distinction of going first again, which means I get no time to think about this but it's not that we haven't thought about it internally.
So I guess what I would just say is or for now there's the global balance and you know certainly U.S. centric impact or view of that for me. You know I would say I see the emerging market universe is 18 months coming out of the bear market. We're 18 months into the next bull market not this. And I would say places like Japan are a couple of years coming out of a 20 year secular bear market just at the early stage of a very massive you know reforms in terms of you know returns on capital an entirely different psyche you know led by the government pensions have in Japan shifting 20 percent of their assets in the direction of equities away from fixed income.
So an entirely new dawn in terms of thinking about the potential for returns on capital and equity and returns on equity investments in a jurisdiction like Japan. So you know a number you know you've got to have a lot of changes happening, politics, things happening in France versus Germany in different years. Within my universe it’s so broad, Argentina you know a year a year into a just, really all of Latin America, about a year into a major 180 degree turn in political direction orientation policy.
So from my perspective you know while I'm certainly cognizant of that the U.S. monetary and the US cyclical pressures and perhaps the adjustment that's going to be required on monetary support, liquidity support, is going to have an impact but I don't believe right now it's going to disrupt the longer term opportunity that I'm looking at in most of my markets. It could have you know some turbulence over the next you know some point in the next year or two. As I think we've all kind of alluded to it so you know and for me as we move through that again you know probably somewhere in between the other two panelists are probably like a year.
I'd like to try to anticipate that the environment I see because the market often is discounting nine months to a year or so in advance. So if you understand what the market's telling you today about where you're headed I think it's going to just depend on how aggressive you know how aggressive will the Fed and other global monetary authorities have to be if we enter that scenario. If they over overtighten gradually into what will become a global slowdown. Then it will be more painful. If they understand that you know they have triggered a cooling off period and they allow things to settle out and don't go slow and don't get too aggressive. Then I feel pretty good about the outlook for the areas I invest in.
I thought I would communicate it from my perspective.
Chad Perbeck: Thank you Michael. And sorry for putting you on the spot that first. Maria any concluding comments on inflationary pressures.
Maria: Yeah I mean I think I don't think that we're going to see the sort of inflationary pressures that are we're talking about you know a 100-200 basis points over the Fed's target. I don't think that that's something that we would see I think Tushar mentioned this earlier in his presentation. Where is that inflation coming from? That's what's hard to really pinpoint. You know I think we're seeing a slowing in inflation in the housing market, obviously health care has its issues. And you know where's it going autos where it's going to come from. So what I do think though is I think we will see especially with you know one of the things that we've done is have a look at what happens with corporate earnings and what happens with inflation a year later. What happens with GDP and what happens with inflation a year later. Is that generally when you start to see this upswing that we saw for example 2017 we’ll typically see that translated into the economy and price levels the following year.
It's about a two to three quarter lag until you start to see those pressures. So we're already seeing an acceleration in inflation if you look at the last three months print and annualize out that trend continued into 2018 like I mentioned earlier should get us closer to the target maybe a little bit of overshoot. But with the Fed also raising interest rates I think they're going to be successful in arresting inflation.
Well our view though is that the Fed will overshoot. They have done that in past cycles. We have an estimate of where the terminal rate should be relative to how much leverage there is in the economy and our estimate is around two point seventy five to 3 percent. So if the Fed gets to two and a half per cent on Fed funds target by the end of this year we're not very far off of them already being near that. But our estimate of the terminal rate and we think that their, especially given where the unemployment rate is, they're going to overshoot but now we're talking about 2019/2020 that I was talking about earlier so for at least 2018 we don't see significant inflationary pressures. So that essentially the Fed for 2018 we think will reach their goal of price stability and that’s all I have.
Chad Perbeck: Okay great. Thanks Maria. Tushar same questions to you on inflation to wrap this up please.
Tushar: Sure. Look I think the sort of easy way to think about this right the first is I'll borrow a quote from someone much smarter than me which is the great economist Rudi Dornbusch who had the line of things in economics and economic life might happen slower than you thought they ever could and faster than you thought they ever will. And so inflation is definitely one of those concepts you have to sort of get in front of this sort of long and very well lagged idea. Suddenly there will come a time when the pressures start to build very quickly because the incremental unit of slack that is being taken out of the economy will command a much higher price at a much quicker right. Right. So I think that's easy to understand. I think what's harder to understand is why we haven't gotten that yet right with so long into this bull market was so long into this economic upswing. Surely by now we should have found that low and there's a lot of arguments to suggest why not right technology is at the forefront of that, globalization is another thing. Regardless of any of these. Right. The important point to think about from our view is the inflation might be the latest bogeyman in a long series of bogeyman that have sort of continued to pop up since the crisis to prevent the scar tissue from healing over properly. And for us a bigger risk we look at it isn't that you know you sort of under prepared for inflation most portfolios have been historically overweight equities for a very long period of time. Now that's your natural inflation sort of protection.
The bigger issue for us is being under invested as a consequence of thinking about one of these bogeymen that we think is still quite far off at the moment. And the risk of being underinvested and sort of missing return targets over those periods of time accumulate. And you know it could compound over a period of time so for us it isn't as much that we look at this and say well we think inflation’s going to be real problem tomorrow. Right if you look at just even average household earnings every jobs report. They’re going up by about five dollars a household every month. So it's not only something that you know you know people are going to be going out and buying Louis Vuitton bags in the next two months or so. It is a slow burn and the economy's going to be managed to reflect that. What I think is important over that period of time is to be invested in the economic growth that's going to spur inflationary pressure. And so for us the risk being under invested is probably a bigger one that I would look at rather than be overly inflationary, hawkish, or sort of concerned.
Chad Perbeck: Great point. Thank you Tushar. With that I'd really like to thank everyone for joining us today in the audience and a real special thanks to Michael, Maria, and Tushar for being with us and sharing their wealth of experience and perspectives if you'd like to stay current on Litman Gregory's views and strategy as well as those of our research alliance members please visit our website www.advisorintelligence.com or you can contact us via phone or e-mail. They're up there on the slide. And with that like to say thank you again. Have a great day everyone.
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