The FOMC Is Plotting "Normalization"

>The Fed intends to “normalize” monetary policy and reduce the size of its balance sheet.

>There would appear to be no opposition on the FOMC to this objective.

>The doves have flown the coop.

>The outlook is for low bond yields and high equity multiples.

The big topic in monetary policy circles these days is the impending normalization of monetary policy: how to unwind QE and bring  the size of the Fed’s balance sheet back to a normal, pre-Crash level.

This is from the FOMC’s April minutes: “Participants generally agreed that starting to consider the options for normalization at this meeting was prudent, as it would help the Committee to make decisions about approaches to policy normalization and to communicate its plans to the public well before the first steps in normalizing policy become appropriate.”

Professor Alan Blinder, a former Fed governor, wrote in the WSJ this week: “The FOMC will have to figure out how and when to exit from two main policies: its near-zero interest rates and its bloated balance sheet.”

In this discussion, the debate is between those who want to normalize now, and those who want to normalize later. There is no debate about why the Fed should normalize policy; normalization as a compelling policy desideratum is just a given. In other words, normalization is being prioritized over less important  policy goals such as growth and employment.

The performance of the economy, and the ability of the economy to provide remunerative employment to the American labor force, are to be subordinated to a technical objective for “good housekeeping” reasons. The Fed’s balance sheet is “bloated”, and that is unattractive.

This way of thinking is nonsense. First of all, how does anyone know what the optimal size of the Fed’s balance sheet is without reference to desired macro policy outcomes? Is there an optimal balance sheet independent of desired policy outcomes? Of course not. Who in the world cares how big or small the Fed’s balance sheet is?

Second, the bigger the Fed’s balance sheet, the smaller the national debt which is good for our nation’s credit. Federal debt held by the Fed is extinguished unless and until the Fed sells it back to the public. Why would the Fed want to sell it back to the public when it doesn’t need to, and when doing so might be contractionary?

Thirdly, if the Fed’s balance sheet is indeed bloated and must be reduced for some reason, why not simply have the Fed forgive most of its holdings of Federal debt? Since the Fed is owned by the Treasury, the forgiveness of the Treasury’s debt would be “eliminated in consolidation” as the accountants say: a meaningless book entry. Oh, but that would reduce the Fed’s “capital”, the ignorant would argue, entirely missing the fact that the Fed prints dollars and doesn’t need a penny of capital, and that the goodwill value of the license to print money is infinite, and thus the Fed cannot be insolvent in dollar terms.

But to return to Planet Earth: Only a fool would subordinate the Fed’s statutory mandates to the shibboleth of “balance sheet normalization”. QE had the effect of creating massive excess reserves. In the event that at some point these excess reserves started leaking into the money supply (which looks doubtful), the Fed has many tools to limit the impact, such as increasing required reserves or open market operations.

The bottom line is that there are no longer any doves on the FOMC.  They are all Austrians now, to paraphrase Richard Nixon. The doves have all capitulated to the siren song of normalization. Like the Fed of the Hoover years, technical concerns will subordinate such trivial matters as growth and employment: above all, the Fed must keep a tidy balance sheet. The fact that every prediction made by the hawks since the Crash has proven false does not diminish the allure of their comfortable useless conventional wisdom.

Investment Conclusion:

Monetary policy will continue to tighten. Growth and inflation will remain low. Bond yields will continue to reflect a low real interest rate and low inflation expectations. Equity multiples will continued to be supported by low bond yields.

Why Bond Yields Are Falling

• Bond yields have been falling since January
• This has nothing to do with monetary stimulus
• Falling yields are a signal of declining inflation and growth expectations
• Stocks are the only option for today’s investor

As usual, the financial media is deeply confused about the relationship between monetary policy and bond yields. Bond yields are falling, and the public demands an explanation! Today’s WSJ gives it a stab:

“Bond yields are – once again — plunging worldwide. The reason for this revived buying among fixed-income investors is that central banks are – once again – signaling their intent to ease monetary conditions in yet another bid to kick-start sluggish economies and forestall a downward spiral in prices, or deflation. The prospect that central banks will continue to inject money into the world's bond markets...has acted as a green light for the world's bond buyers.”

Bond yields are declining because central banks are pursuing inflationary policies. Wasn’t it just yesterday that we were being told that quantitative easing would cause hyperinflation and double-digit bond yields? Now we are supposed to believe that monetary stimulus causes bond yields to fall. Inflation is deflationary.

A second myth being retailed now is that central banks have been providing monetary stimulus since the Crash:

"The global economy hasn't fired up despite all the heavy monetary stimulus,'' said Mary Ann Hurley, vice president of trading at D.A. Davidson & Co...“We continue to stay in this ultra-loose monetary-policy environment" which supports bond prices, said Jason Brady, head of fixed income at Thornburg Investment Management. (in today’s WSJ)

It should by now be evident to any market participant who has taken Monetary Policy 101 that there has been no “heavy monetary stimulus” and that we are not in an “ultra-loose monetary policy environment”. There are a number of ways to judge a central bank’s policy stance, and almost all of them indicate that none of the major central banks (aside from the PBoC) has been providing “massive stimulus”. These measures include money growth, inflation, nominal growth, real growth, expected inflation and bond yields. For the Fed, the ECB, the BoE and the BoJ, all of these indices have been flashing “TOO SLOW” since the Crash. Fitful efforts at QE have failed to move any of the dials.

Falling bond yields are not about the prospects for more stimulus. They are instead a signal of the market’s loss of faith in the ability of the central banks to provide adequate monetary stimulus. The market looks into the future and sees very low money growth, declining velocity, less than 2% inflation, 3% nominal growth and 1% real growth. Such an outlook justifies a 10-year yield of 2.5%.

And by the way, we are not in a “new era”--we are in an old era called the mid-20th century, when bond yields remained below 3% for twenty years, from 1935 to 1956. Of course, this is all new to the baby boomers, who can only remember the inflationary era after the breakup of Bretton Woods. We will need to erase those inflationary memories and reacquaint ourselves with our parent’s era when 3% bond yields were considered high, and a 2.5% yield was considered normal. There is nothing “extreme” about low inflation and low interest rates.

What About Stocks?

Declining bond yields are bullish for stock prices. The 10-year yield has declined from 3% in January to 2.5% today. Stated differently, the PE on the 10-year bond has risen from 34 to 40. This raises the equity premium which makes equities more attractive, and justifies a higher multiple. Today, the forward multiple for the S&P is 15.8x which represents an earnings yield of 7%, which is certainly more attractive than 2.5%.

Bond Yields Fall As Fed Tapers Purchases--Markets Perplexed!

• Bond yields are falling despite the Fed’s decision to taper QE

• This is because QE has not affected the economy
• Falling bond yields are not bearish for stocks

Since the FOMC began to taper its bond purchases at the beginning of this year, the 10-year Treasury yield has declined by 40 basis points from 3.0% to 2.6%. This has caused puzzlement in the financial commentariat:

“The demand for Treasury bonds is all the more remarkable because the Federal Reserve is ending the Treasury-bond-buying program it has used to keep interest rates low. That normally would reduce Treasury demand and push yields higher. Instead, Treasury prices have risen and yields declined.” (WSJ, 05 May 14)

This amazing phenomenon does not come as news to readers of my blog. I have been calling attention to the tightening of monetary policy for the past two years. The fact that the Fed has given up on QE is a signal of even greater tightening, which is entirely consistent with falling bond yields. Today’s bond market is looking at a very subdued horizon:

• 6.0% money growth, the impact of which is further diminished by declining velocity;
• 1.2% inflation, which is 40% below the Fed’s target;
• 3.7% nominal growth, which is inadequate to sustain anything like 4% real growth--which was in fact zero (QtQ) in the first quarter;
• A complete absence of any discussion at the FOMC of taking concrete steps to accelerate money growth.

We are also told that falling bond yields are a bearish signal for stock prices:

“One sign of the current worry is the strength of U.S. Treasury-bond prices. In times of economic optimism, investors normally buy risky assets like stocks, not safe Treasury bonds.” (WSJ, 05 May 14)

It is true that the depressed economic outlook is bearish for the rate of corporate earnings growth, but this does not translate into a bearish outlook for equity prices. That is because, ceteris paribus, declining bond yields increase the relative premium being paid to stockholders. Damodaran at NYU calculates the equity risk premium at 5.1% as of May 1st. This compares with an all-time high of 7% during the Crash and an all-time low of 2% in 1998. The current level is considerably above the historical mean. Stocks offer a relatively attractive prospective return in a world of ultra-low interest rates.

The ERP is elevated because bond yields are very low, not because of the outlook for earnings growth. The threat to current stock multiples is not low earnings growth, but instead higher bond yields. Given the current subdued outlook for growth and inflation, I see little reason to expect higher bond yields anytime soon.

There is a widely-held view that bond prices have been artificially supported by QE, and that the end of QE should herald lower bond prices--that financial markets have been artificially supported by “massive monetary stimulus”. The empirical evidence suggests that bond prices were not inflated by the Fed, and that the withdrawal of QE will not result in lower bond (or stock) prices.

My view has been that, because QE has failed to increase money growth, inflation and nominal growth, it has not raised bond prices. This is because inflation expectations have declined during QE, which should not have occurred during a period of “massive money printing”. Pre-crash, 10-year inflation expectations were above 2.5%; today, they are 2.2%--despite a quadrupling of the Fed’s balance sheet. The tapering of QE is a signal that nothing more will be done to raise inflation expectations, hence the rise in bond prices. QE was nothing but a sideshow: a huge distraction from the Fed’s continuing failure to get control of money growth.

Implications Of Weak Growth For Financial Assets And Monetary Policy

My economic forecasting prowess has been vindicated by the awful first quarter GDP growth data, which show that the economy is on the brink of recession. I have been saying since October that the economy is at risk of both deflation and recession. I have based my pessimistic outlook on the decline in money growth and inflation over the past two years, and on the Fed’s perverse decision to further reduce monetary stimulus in the face of subpar growth and inflation.

What does this depressing growth scenario mean for financial assets? It is bullish for both stocks and bonds, and bearish for inflation hedges like precious metals.

Implications for Bonds: Bullish

Low growth is bullish for bonds because it removes the risk of accelerating growth,  delays further the possibility of higher short-term interest rates, and anchors inflation expectations at their current low level. The big bond selloff has already occurred, during 2013, when the 10-year yield doubled from 1.5% to 3%. This year, bond yields have fallen back to 2.65%. I don’t like bonds because they yield nothing, but I don’t see the  “inevitable bursting of the bond bubble” happening any time soon.

Implications for Stocks: Bullish

Low bond yields are bullish for equities. Stated differently, high bond PE ratios support high stock PE ratios. (Today, the bond PE is 38x and the stock PE is 19x.) This relationship is captured by the equity risk premium, which compares the demanded return premium for stocks over bonds. On Friday, Aswath Damodaran at NYU will publish his calculation of the ERP for the first of the month. For April 1st, he calculated the ERP at 5.15%, which is on the high end of the range since 1961 (the range is roughly 2% to 6.5%). This means that you are being paid a historically high premium for owning equities.

The ERP is elevated despite high PE multiples because bond yields are so low. Skeptics say that the ERP depends upon strong earnings growth and abnormally low interest rates. The are wrong about earnings growth: the ERP does not reflect or depend upon strong forward earnings growth. They are right about interest rates, but rates are abnormally low because inflation is at a 50-year low. The 1Q14 growth data suggest that rates will remain abnormally low for some time.

Implications for Metals: Bearish

Precious metal prices should move in accordance with inflation expectations, and indeed both inflation expectations and metals prices have been declining since 2012. The current growth and inflation outlook suggests that metals prices will continue to decline until the Fed can get a grip on money growth.

Implications For Monetary Policy: Nothing

The 1Q14 growth numbers represent a victory for the doves and a defeat for the hawks. Once again, the hawks have been shown to have a complete misunderstanding of the Fed’s current monetary stance, which is contractionary, not stimulative. Once again, the doves have been proven correct: tapering at this point in the cycle is insane. This might give Yellen the ammunition she needs to reverse the decline in money growth, but history suggests that she, like Bernanke, will fail. For the Fed to do a complete 360 will require negative growth and higher unemployment, both of which are likely. Then we might see a policy rethink.

Knocking Down Jim Cramer's Bear Case

Jim Cramer just published “The Bear Case in 10 Easy Lessons”, which lays out the arguments for lower stock prices.  He throws these “lessons” out not as an argument but as discussion items, a sort of straw man. Here is his case and my observations:

1. Something is very wrong with the market when we get strong news out of the economy and interest rates plummet. That's a fear of an unknown unknown. What's the point of buying when there is something lurking?

Interest rates are falling because inflation is falling while the Fed is tapering. Low bond yields support low earnings yields (high PE ratios).

2. When interest rates plummet, the banks plummet, particularly now that the short rates aren't going higher. Banks are the linchpin of all big rallies, and we have lost them.

There is no doubt that banks are hurt by a low and flat yield curve which makes retail deposits expensive and compresses margins. Bank earnings are under pressure. But the current ERP is a result of low interest rates, and doesn’t depend on robust earnings by banks or corporates. And also, low interest rates may hurt banks but they help corporates.

3. There is no price where the insiders won't sell these extended techs with no dividends or earnings.

Tech goes its own way and is always hard to value using conventional tools. The valuation of blue chips is not so hard, and is poorly correlated with tech. If a tech selloff pushes down blue chips, buy them.

4. We have had a big run from the bottom, almost a triple, so it has to be out of gas and extended. It was just high-multiple stocks. Now it is every stock.

Distance from the bottom is not a useful index of valuation. Stocks were severely undervalued in 2009, when earnings were cyclically depressed. The fact that they are higher today contains no information about value.

5. We've seen this movie before in 2000. In fact, it was this week to the week that we were really beginning to thrash with the really awful dot-coms crashing daily and the insiders still selling no matter what the case.

The 2000 movie was of a classic equity valuation bubble, when the broad market equity risk premium was at an all-time low. That is not the case today; the ERP is at the high side of its normal range suggesting value.

6. Japan's a disaster.

Japan has been a disaster since 1991 and it has never had any impact on the US equity market. As a result of Shinzo Abe’s reflationary policies, Japan is finally beginning to recover, and now has higher inflation than the US.

7. China's a disaster.

China is not anything like a disaster. China remains the best performing economy in the world, although it slowing a bit as the PBoC reins in credit growth (which is a good thing). China prints its own money and has $3.5 trillion in external reserves.

8. The world's being kept afloat by central bank fiddling.

Global inflation is lower than it has been in 50 years. Global money growth is in the single-digits (almost zero in Europe). The IMF is warning about deflation. The world is kept afloat despite central bank incompetence.

9. The initial public offering flow doesn't stop.

IPO volume is suggestive of frothy sentiment and is a warning light. However, other measures suggest that we are not in an equity bubble comparable to prior episodes such as 1999. If equity prices fall from their current levels, market valuations will become more compelling.

10. Earnings will be terrible.

Future top-line and bottom-line growth are limited by anemic nominal GDP growth and by potential capacity constraints. However, from a valuation perspective, weak earnings growth is fully offset by low bond yields (i.e., a low discount rate for future cashflows). The current price-earnings ratio for 10-year governments is 38x with zero potential earnings growth, while the S&P ratio is half of that at 18x with potential (albeit weak) earnings growth.

Implications Of Deflation Risk For The Equity Market

• Deflation poses a risk to current stock market valuation.
• Inflation is falling and the risk of a deflationary episode is growing.
• Deflation is a monetary phenomenon caused by inadequate money growth.
• The Fed appears to be unable or unwilling  to raise the rate of inflation to its targeted level.

In a recent post I argued that the stock market is not overvalued, and that the equity risk premium is historically high, or at least within a normal range (depending on your calculations).  I cited a study by Duarte and Rosa at the NY Fed which found that:

“The ERP is high at all foreseeable horizons because Treasury yields are unusually low at all maturities.  In other words, the term structure of equity premia is high and flat because the term structure of interest rates is low and flat.”

In other words, the market is not overvalued in the context of bond yields. I further argued that I don’t expect bond yields to rise because of the subdued inflation outlook. Today I will discuss the other side of the inflation equation: deflation risk.

Research suggests that the stock market sweet-spot for inflation is between 1% and 6%. The market reacts negatively (i.e., it demands a higher risk premium) to inflation levels that are above or below this range. The stock market doesn’t like high inflation because it raises the discount rate for future cash flows, and it  doesn’t like low inflation/deflation because it reduces corporate earnings and magnifies debt.  You will recall that the market performed badly during the 1929-33 deflation, the very low inflation in 2002, and the deflation of 2009.

Deflation poses a risk to today’s market outlook. Consumer price inflation has fallen to low levels, producer price inflation has been bouncing around zero, commodity prices have been falling for three years, while the price of oil has been flat.

As we know from Friedman and Bernanke, deflation is a monetary phenomenon. Today’s low inflation is a result of low velocity-adjusted money growth (M x V). Strong growth in the monetary base (QE) has not translated into money growth, and the current moderate money growth has not translated into equivalent  nominal growth (P x T) due to falling velocity. Hence, we have  subpar nominal growth and deflationary pressures.

It is at this deflationary brink that the FOMC has chosen to taper monetary stimulus. The rationale for tapering in the face of below-target inflation is that the current sub-target level is temporary and inflation will rise (as monetary stimulus falls). Not every member of the FOMC buys this logic, according to the minutes of the latest meeting:“A couple of participants expressed concern that inflation might not return to 2 percent in the next few years.” What these two dissidents got was a meaningless promise: “members agreed that inflation developments should be monitored carefully.” In other words: ignore the numbers, the taper will continue.

When Ben Bernanke gave his famous helicopter speech in 2002, he listed five reasons why “the chance of significant deflation in the United States in the foreseeable future is extremely small”. These reasons were:

1. The stability of the US economy.

2. The strength of the financial system.

3. Stable inflation.

4. Anchored inflation expectations at a non-deflationary 3%.

5. The willingness and ability of the Fed to take whatever means necessary to prevent significant deflation.

Let’s look at these five factors in today’s context:

1. Economic stability: Check; the economy is stable.

2. Strong financial system: Check; we are not having a financial crisis.

3. Stable inflation: No; inflation has been falling since 2011.

4. Anchored inflation expectations at a noninflationary 3%: No;  inflation expectations have been falling since 2010 and are now below 2%.

5. The ability and willingness of the Fed to meet its inflation target: No, current inflation is running at half of target, and the Fed is withdrawing stimulus.

So today’s economy currently meets three of Bernanke’s five deflation risk criteria. Hence the recent concerns being expressed by the two dovish committee members. In his speech, Bernanke listed steps that the Fed could take to counteract deflationary pressures:  

1. Cap the entire yield curve;

2. Offer zero interest loans to banks;

3. Buy foreign government debt;

4. Monetize Treasury purchases of private assets.

Twelve years later, despite the clear risk of deflation, all of these tools remain unused--not even during the 2008 deflation.

Conclusion:

Current market valuations are merited as long as inflation remains within the moderate range (1-6%). Given that current inflation is at the bottom of that range, and that the Fed is reducing monetary stimulus, the principal risk to today’s  market valuation appears to be lower inflation or outright deflation.

Bond Yields And The Equity Risk Premium

Summary

• High PE ratios do not signal an overvalued equity market.

• Multiples are high because bond yields are low.
• Bond yields are not artificially depressed by the Fed’s bond-buying.
• Bond yields are likely to remain low, given the inflation outlook.

Duarte and Rosa at the NY Fed say that the equity risk premium is elevated at all horizons because the term structure of interest rates is depressed at all horizons. They say that the only thing that could reduce the ERP would be higher bond yields, and that earnings and dividend growth rates only play a minor role. That means that an equity investor cannot have an informed opinion about the stock market without also having an informed opinion about the bond market.

Stock market bears say that bond yields have been artificially depressed by the Fed's purchase of $3T of Treasury bonds, which represents a material proportion of the total float (about the same as the PBoC's portion). But I don't believe that QE is the reason why yields have fallen. If QE had been effective and had stimulated money growth, it would have raised bond yields. The idea that printing money depresses inflation expectations and bond yields is upside-down.

Bond yields are low because QE has failed. QE has had no impact on money growth or inflation or inflation expectations. Money growth since the crash has been anemic (~6%) and inflation and inflation expectations have trended steadily downward. We have gone from a disinflationary economy to a borderline deflationary economy. This is not good for workers (or earnings growth), but it justifies high PE ratios.

Inflation has not been this low since before the Vietnam war, and inflation expectations are very near their all-time low. Bond yields are at Eisenhower levels because inflation and inflation expectations are at Eisenhower levels. When you couple this with the FOMC's decision to reduce monetary stimulus in the face of declining inflation and inflation expectations, it's hard to build a case for higher bond yields. Since bond yields are unlikely to rise, then the outlook for stock prices remains bullish.

Decoding The NY Fed’s Latest Paper On The Equity Risk Premium

I read academic research papers so that you don’t have to. The NY Fed has recently released a working paper on the ERP. This paper follows a previous paper published last year, which reached similar conclusions. Both papers conclude that the ERP was at an historically high level in 2013. Further, the authors conclude that the ERP is a valid tool for estimating equity market value, and that ERP tools are superior to PE-related tools such as Robert Shiller's CAPE.

You really can’t value stocks through the cycle without reference to bond yields. Otherwise, we would just be looking at PE ratios and be thinking that stocks were expensive when rates were low (2002, 2009, 2012, 2013, 2014). Bottom line: ignore the PE and ignore the cyclically-adjusted PE (the CAPE). Only look at the ERP (earnings yield minus the risk-free rate) or--my preferred index-- the ratio of the ERP to the risk-free rate. Equities can only be valued by reference to interest rates.

If you agree with me, and accept that the ERP/RFR ratio is THE index*, then you should sell everything you own and put it into equities. If you were a real hombre, you would also borrow up to your debt capacity and buy stocks (please don’t do that!). If you accept the internal logic of the ERP/RFR ratio, then you should be overweight equities. Below I have excerpted from the NY Fed’s most recent paper on the ERP, and have provided my parenthetic exegesis. The NY Fed’s words are italicized.

There is broad agreement across models that the ERP has reached historical heights [as of mid-2013] even when the models are substantially different from each other and use more than one hundred different economic variables. Our preferred estimator places the one-year-ahead ERP in July 2013 at 14.5%, the highest level in fifty years and well above the 10.5% that was reached during the financial crisis in 2009.

Translation: The best time to buy stocks in our lifetimes was last summer. If you mentally adjust the ERP to reflect the subsequent market appreciation, we are still in historic territory.

The ERP is high at all foreseeable horizons because Treasury yields are unusually low at all maturities.  In other words, the term structure of equity premia is high and flat because the term structure of interest rates is low and flat.  Current and expected future dividend and earnings growth play only a minor role.

Translation: The reason that stocks are a buy is that bond yields are at deflationary levels.

A high ERP caused by low bond yields indicates that a stock market correction is likely to occur only when bond yields start to rise.

Translation: Unless something happens to upset current inflation expectations, the ERP will remain elevated into the foreseeable future, making stocks a compelling investment.

Another implication of a bond-driven ERP is that we should no longer rely on traditional indicators of the ERP like the price- dividend or price-earnings ratios, which all but ignore the term structure of risk-free rates.

Translation: Shiller’s CAPE and similar crude valuation measures are flawed because they ignore the expected returns from alternative investments. When rates are low, PEs are high. That doesn’t make stocks expensive. We should compare the PEs of stocks with the PEs of bonds. Right now the 10-year PE is ~35x--and bond yields can never rise.

The current high levels of the ERP are unusual in that we are not currently in a recession and we have just experienced an extended period of high stock returns, with 60% returns since July 2010 and almost 20% since the beginning of 2013. During previous periods, the ERP has always decreased during periods of sustained high realized returns. It is unusual for the ERP to be at its present level in the current stage of the business cycle, especially when expectations are that it will continue to rise over the next three years.

Translation: We are living in a period of unprecedented prospective equity returns. This an historical opportunity to buy stocks.

Our analysis provides evidence that is consistent with a bond-driven ERP: expected excess stock returns are high not because stocks are expected to have high returns, but because bond yields are exceptionally low.

Translation: You should only be bullish on stocks if you are also bullish on bonds. That requires an opinion that the FOMC will continue to be unable to raise inflation and inflation expectations.

There was a moment when I thought that Yellen would be the catalyst for higher inflation expectations; I was wrong. She is a catalyst for nothing. We should expect low inflation, low bond yields, and an attractive equity yield premium until stock prices go much higher. Investors who currently hold metals, cash and bonds will look back on 2014 and regret it. Where we are today is 1933, 1974, 1980, 1987, and 2009.

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* It was subsequently explained to me (at Seeking Alpha) that the ERP/RFR ratio is unreliable because of its sensitivity to small changes in the RFR when the RFR is very low. Consequently, I suggest that we focus on the ERP itself.