March 25, 2019– U.S. Treasury yield inverts: Is this a bad omen for the stock market?
IPOs: A great buy or is It Probably Overpriced?
Canadian banks: Is it time to go short?
Fed stands pat on rates: Where to from here?
Discussion: The Danger of Return Targeting
Welcome investors to the Absolute Return Podcast. Your source for stock market analysis, global macro musings and hedge fund investment strategies. Your hosts Julian Klymochko and Michael Kesslering aim to bring you the knowledge and analysis you need to become a more intelligent and wealthier investor. This episode is brought to you by accelerate financial technologies. Accelerate because performance matters. Find out more at www.Accelerateshares.Com.
Julian: Welcome ladies and gents to Episode 6 of the Absolute Return Podcast, I am your host Julian Klymochko.
Mike: And I’m Mike Kesslering.
Julian: We have an exciting show for you guys today. We are going to talk about a number of super cool stuff that happened in the markets this week. And number one well we want to talk about the danger of return targeting. We’re going to talk about the Fed standing pat on rates and where they’re going from here. We’re going to talk about a big short in the Canadian banks. Also going to discuss IPO’s. Are they a great buy, or are they probably overpriced? And lastly talk about the U.S treasury yield curve inverting and what that means for the economy and the stock market.
Big news in the bond markets with the U.S treasury yield curve inverting the first time since 2007 and a yield curve inversion is a really big deal. Because a yield curve inversion is one of the most popular leading indicators in terms of predicting a recession and so what happened was there are three-month T-bills, short term bills that you buy that mature over three months and if you go out on the long side of the curve, there are 10-year treasury bonds. So, in a well-functioning market the three-month yield is typically lower than the 10-year yield. Obviously, you want a higher yield to have to take on that interest rate risk of holding longer duration paper out to ten years. But what happened is that the 10-year yield had actually declined below that of the three-month, which is a pretty big event. Like I said it hasn’t happened since 2007 and we all know what happened in 2007. You know a number of call it eighteen months later was the commencement of the global financial crisis. Which was one of the worst recessions in a generation. So, it’s definitely a yellow flag here. Mike what are your thoughts on it?
Mike: Yeah no I guess I mean like you had mentioned its kind of a duration play where investors have more appetite for the tenure. But you know when you say that it’s yellow flag I guess how effective would you describe it as an indicator?
Julian: Well first I’m going to get to you know what caused this. You’ve had the fed hiking rates on the short end of the curve and you know the fed increasing their policy rate to now kind of in the two and a quarter range has increased. It really affects the shorter-term rate. So, it will affect the three-month yield and so you’ve had that increasing steadily over the past number of years. Then on the long side you had a couple of negative data points on the economic side, specifically U.S. manufacturing data came in below estimates this week in addition to German manufacturing data, so it’s not just the U.S you really have a global economic slowdown. Not talking about recession currently. But just economic numbers coming in below expectations, you actually saw the 10-year yield in Germany hit zero. So, it can go a lot lower than where it is in the U.S and so this year the ten-year slipped to kind of in the 2.45 range and this indicator in terms of accuracy, it’s kind of all over the map. You can’t really believe that it’s set in stone that we’re going to enter a recession right away. Its track record is relatively mixed I’ve seen an analysis that shows kind of recession beginning say between six months and all the way out to two to three years after the yield curve inverts and so what happens? How do you get a yield curve to go back from an inversion? Well have the fed cutting rates or a higher economic growth that will increase yields on the long end of the curve. So, this is certainly one to monitor. Make sure you’re comfortable with your asset allocation, not to lever it up in the stock markets or anything like that. It’s just a kind of sign of caution to make sure you got all your ducks in a row and just be on notice that you know this signal is calling for a potential recession in the near term say next year or two and as we know recessions tend to beget bear markets in the stock market. So that’s something worthwhile considering and keeping your eye on.
Mike: And that’s something that we’ll be bringing up is the fed I guess in later on. But now the market is indicating that there could be an actual cut by the end of 2020 which would go along with the thesis of a recession.
Julian: Yeah certainly we will have a more intense discussion of where we’re at in the cycle and fed cycles specifically later in the podcast. So, I’ll get to that fairly shortly. But for now, we’re talking about IPOs. A big IPO hit the market this week with 166-year-old blue jeans giant Levi Strauss & co going public for the second time in its existence. Its stock actually rallied over 30% in its initial day of trading – a real big hot IPO for a non-technology company. Which was really interesting you don’t tend to see that. But I mean talk about this deal it was in fact ten times oversubscribed, just voracious demand for this one and the company wasn’t even really raising money. It was largely an exit for descendants of the founder Levi Strauss, who founded the company you know what hundred seventy years ago almost. So, members of the Haas family, they sold 21 million shares which was nearly 400 million dollars into their jeans and so I’m always kind of skeptical of these types of IPOs. But nonetheless it was very very well received by the market, which was pretty interesting. I mean they had a value, a market value of 8.7 billion after that initial IPO pop and talking about fundamentals, Levi’s has 5% of the global jeans market. As I indicated this is actually the second time it went public. They first went public in 1971 and then went private again via leveraged buyout I believe in the 80’s. So it’s been privately held by the Strauss descendants, this Haas family for a number of years and so they’re trying to monetize it and the reason that they’re doing that is they’ve had recent strong corporate performance and a very strong market for IPOs and I looked at some of their historical financials and I was actually pretty shocked that in 1996 Levi’s had sales of 7.1 billion and by 2001 those have dropped 42 percent to 4.1 billion. So really got crushed in the late 90s and they’ve only recovered to 5.6 billion. So still dramatically lower sales than they had in the mid-90s and so certainly not a growth business. However, you had a massive IPO pop and a lot of interest, a lot of eyeballs looking at this one.
Mike: Yeah, I mean also in terms of its it’s actually priced like a growth stock when you look at the valuation is based on my math that’s trading about 30 times earnings right now. Which would indicate you know a really strong growth company, not a you know more of a consumer company that’s in kind of a cyclical decline.
Julian: Yeah, they mentioned revenue rose 14 percent over the past year. But like I said you look at the longer-term trend, they really rescued themselves out of a tailspin in the late 90s. But you know the jeans market really is only expected to grow perhaps 2 to 3 percent. So, in line with GDP it’s not necessarily a large growth industry, but it shows how hot this IPO market is and it’s a really interesting and a divergence from what we talked about the inversion of the yield curve predicting a potential recession and bear market. Then you look at the IPO market and that window is wide open, super bullish and a lot of other startups can start coming public right?
Mike: Yeah absolutely and one thing to highlight in this IPO is you had mentioned the Haas family. But the dual class structure for shares is actually quite interesting is they will actually control, I believe they will control about sixty six percent of the shares. But well through a super voting structure will control ninety nine percent of the votes and so typically this is done in a company with a visionary founder. You know thinking of Facebook or you know any of the tech companies such as Lyft is coming to market with a structure like that, snap came to market with one.
Julian: No votes for the shares.
Mike: Yeah that was actually a very unique structure. Where yeah there was no voting rights whatsoever and ironically look at their share price since the IPO they’re down about fifty percent.
Julian: Yeah yeah and so on this Levi’s deal by super voting you mean ten votes for shares for the descendant family.
Mike: Yes yes.
Julian: It’s real interesting in my opinion an example of poor corporate governance not only do you have a massive exit the family selling their shares, but then they’re retaining pretty much total control of the company through ten to one voting shares when everyone else in the IPO only gets one vote. So, you know not the best corporate governance there. Then I wanted to talk about IPO performance in general as we’re calling this podcast the IPO, is it probably overpriced and so we have an analysis in front of us here that shows that on average there is a big IPO pop. I’m saying since 1980 the average IPO has popped about eighteen percent on the first day. However, over the next three years they have underperformed the market by roughly nineteen percent and so it just goes to show you I believe IPOs, they’re generally not a good buy and the way to play them if you can be to get in on the first day and then just make it for a quick flip. Capitalize on that IPO pop and just exit. Because the people buying after the IPO will typically see underperformance and I think that there is that IPO pop because everyone’s looking for that rare lottery ticket like a Microsoft or Amazon. But the vast majority of them if you buy them all, you’ll most certainly underperform the market at least according to our historical data. But looking at the IPO ETF it’s been on a tear this year. What is it up? 35 percent or so and so you know it doesn’t work every time. But I believe on average that initial public offerings are overpriced and will likely underperform on average on a go-forward basis.
Mike: And another thing to look at in any of the IPO analysis is that it typically is dependent upon being part of that initial allocation, which is very important, and part of the initial subscription and you know the hot IPO is by definition like this one was ten times oversubscribed. So, it’s very difficult to be a part of those IPOs. So, you’re likely you know as a normal trader you’re going to be buying in after the larger initial pop has already happened.
Julian: Yeah definitely there’s certainly some adverse selection where the best ones you’re not getting in. So, the ones that do poorly are the most likely allocations that you’d get unless you’re paying you know tens of millions of commissions per year and you’re on the VIP or president’s list for their brokerage firms. But you know that’s pretty unlikely. So, in general I’d probably stay away from these.
Interesting article this week in the financial times highlighting Steve Eisman and you may know him from the movie and the book The Big Short. He was played by who Steve Carell and so he’s infamous for short selling financial companies and I believe subprime mortgages and making a big bet against those prior to the global financial crisis and really profiting off their decline. So there’s an article this week highlighting his, he’s been raising his bets against Canadian bank stocks and blaming that potential future adverse performance on slowing economic growth in Canada, softening housing market and a decline in credit growth and all of these would potentially cause increased loan losses at the Canadian banks leading to declines in net income and ultimately poor share price performance and if we look at the numbers, wagers by short-sellers against the banks have increased 19% year-to-date up to twelve point three billion. So fairly sizable shorts there and it’s a really interesting situation. What are your thoughts on it?
Mike: Yeah something that he mentioned in his analysis and the article was that the Canadian banks may not be mentally prepared, since they are an oligopoly. But the fact that they’re an oligopoly could arguably be one of their main strengths and why investors have invested in the Canadian banks historically and why they’ve had such strong pricing power and being such a strong dividend grower.
Julian: Yes, certainly that’s a good point. I believe I read an analysis recently that compared the bank stock performance total return against Berkshire Hathaway and Canadian banks actually outperformed Berkshire on 10-year basis and so certainly strong performers and if you look at the return on equity of these companies, they certainly have been outperforming their U.S. counterparts by quite a large margin. So, it just you know lends credence to the theory that they’re somewhat uncompetitive with each other. It is an oligopoly, it’s really only six major banks in Canada and they don’t really compete all that aggressively against each other and the result is excess profitability for the corporations and the shareholders owning those. But with respect to short selling, I’ve been following the story for a very long time and this initially first came up in 2013 and has kind of been circulated every year since. So, you got to think about you know are they early or just wrong and I think when you’re six years early and the trade has gone against you massively, because Canadian banks have had pretty strong share price performance since 2013, probably up on a total return basis about 50 percent inclusive of dividends over that time period. So as a short seller I think it’s pretty clear they’ve been pretty wrong on this one thus far. You know it could go the other way. But you know this trade not looking too good as it’s been so far.
Mike: And when you mentioned 2013 I think you’re referring to Steve Eismans initial pitch at the Ira Sohn conference shorting the Canadian banks. So, I assume he’s had some form of the trade on. But as well he did mention that this set of positions he put in place in 2018. So, over the last 12 months he probably would have broken even or around even on a total return basis. But with regards to this one aspect of shorting the Canadian banks is that they’re a dividend pair. So, Julian what are some of the challenges when you’re shorting a company that pays a dividend?
Julian: Yes, so when you short a company you have to pay out the dividend that it pays. So, I don’t actually consider the dividend all that much. I just take into account that’s part of the total return. So, you know efficient markets would say if a $100 stock pays a $1 dividend, the stock will decline to 99 on the day. So, I take that into account in terms of total return. But it certainly grinds you down over time. In addition, you typically have to pay borrow in order to short the stock. So, it’s an expensive proposition and markets typically go up over time. So short selling certainly isn’t for everyone. Especially on net short basis – typically people shorting stocks have offsetting longs at least large in values. So, you can have some cash flow and capital gains income from those to cover your shorts. A couple other points that I wanted to touch on the story and so Eisman says that this is not The Big Short Canada. He’s not calling for a housing collapse, he’s more so calling for a normalization of credit which would lead to probably just earnings weakness for the banks. No sort of bankruptcies like you had in the U.S and a massive credit crisis. It’s nothing along those lines and the other thing that I wanted to note is that in Q1 so far this year four of the six biggest banks in Canada, they actually missed analyst consensus estimates for their earnings for the quarter. So, you know they haven’t been doing great, but thus far this short thesis just hasn’t played out.
Mike: Yeah and I think you mentioned the just credit normalization and so really that’s all he’s looking for and it would kind of an example of a very sexy headline, where the underlying story is you know he didn’t give any specific banks that he was just shorting them in general. So yeah kind of look beyond the headlines.
Julian: Yeah short selling typically the hardest part is the timing and the timing on this one has thus far been quite elusive.
Now on to the Fed. So as expected the U.S federal reserve kept its policy rate unchanged this week at two point two five to two-point five percent after their two-day meeting this week. So, fed chair Jay Powell indicated that rate hikes in 2019 are likely off the table. Not just that, but they also indicated, it gave guidance that they would slow their balance sheet runoff and also end it entirely by September and so why’s he so dovish these days? Well a number of reasons. He blamed below target inflation slowing economic growth and so now the market is thinking you know is the fed done its rate hike in cycle for this economic cycle and what’s next? Are they going to start cutting rates and certainly the market is beginning to price that in. Certainly, as we did previously discuss on previous episodes of the podcast is that you know the rate hiking cycle did seem like it was over, and the fed just confirmed that, and the market is increasingly pricing in rate cuts this year. I think estimates are as high as 40% now, what are your thoughts on this?
Mike: Yeah, I guess some of the criticism on Powell has been his communication with markets. With the market sometimes not understanding what his intentions were. I guess this would be a case of him really clearing up any uncertainty whether there was going to be any continued rate hikes, that’s now off the table. One other thing that I would mention is that you know being at these historical low rates you know 2.25 to 2.5 percent. It really lessens the margin for error when, if and when there is the next recession for the number of cuts that they can have down to zero. It generally just limits that flexibility in the long run I would say. But yeah yeah and I guess the other aspect and we did discuss this on a previous podcast would be whether this is finally Powell really capitulating to Trump.
Julian: Yes, number of things to discuss here as we’re talking about the treasury yield inversion. So, the Fed’s dovishness here really caused a pretty big decline in 10-year yields. I see that you know before the meeting they’re above 2.6 percent and they think near the end of the week they’re more around two-point four five percent. So pretty big decline on the yield side. Not just that but they’re also dovish in terms of unwinding their extremely large balance sheet. So, as you noted a big risk that people see going forward is that the fed wanted to normalize policy and whereas normalized policy, well people were thinking that’s more in the 4 to 5 percent range right. If you envision 2 percent inflation, then real rates are really you know 25 basis points at this point. But if we look at some precedents here back in 2006 the end of its last tightening cycle, real rates were at 2.75 percent. So, what that means with the 2 percent inflation? That means the policy rate at nearly 5 percent and then the prior cycle in 2000, you had a 4 percent real rates. So that would equate to a policy rate of about six percent. The other thing that’s pretty dovish about the fed stance currently is the three point five trillion on it’s, three point five trillion of bonds on its balance sheet. Which is actually equal that’s seventeen percent of GDP and you look back to 2006, their balance sheet was six percent of GDP. So relative you know their balance sheet has nearly tripled in terms of size versus thirteen years ago. So that’s something to consider. The other thing is that they’ve been decreasing their growth projections. So back in September they envisioned two-point five percent growth and that’s declined to two-point one percent and a lot of their dovishness here and the fact that they really seem to end their rate hiking cycle and also ending this balance sheet runoff, it’s just they’re blaming it on inflation. They have a two percent inflation target, it just hasn’t made it there and they were thinking with unemployment declining you had really good economic growth in the U.S last year, at three percent. They figured that they’d start to see some inflation pressures. But they’re just not saying that in the numbers. So, they think that they are fine on the rate pause for now. But as you say there is some concern on lack of ammunition. Say there is a recession in the next couple years, the Fed seems to be lacking in flexibility here with the policy rate that doesn’t allow for too many cuts. If the economy does hit the rocks and they still have a fairly sizable balance sheet. Can they take on you know more assets on to the balance sheets? So ultimately the Fed chair, he’s really trying to have a balanced position here. Trying to balance between having policy that’s too loose and spurring unwanted inflation and asset bubbles. Then on the other side of the coin is a central bank that’s too tight, that’s raising rates and aggressively running off its balance that could prematurely end the expansion and ultimately cause a recession. So, he’s really you know got his hand on the accelerator here of the economy and really trying to maneuver it. Such that he can land this one in a smooth fashion.
Mike: And when Powell was first appointed to the Fed chair, it was noted that he did come from a risk management framework. So that has kind of followed that thesis. But the other aspect is the, what you had mentioned were there long-term growth projections and just the delta between those projections and that of the white house being low 2% by the fed and three to four percent long-term through the Trump white house.
Julian: Yeah, I would certainly you know put my faith in the federal reserve and a team of professional economists other than Trump. But talking about those growth numbers and I got some charts in front of me here and so over the past kind of eight / nine years, the Fed’s long-term economic growth projections have actually steadily declined from 2.6 percent to 1.9 percent. I also have the chart in front of me of the probability of a fed rate cut in 2019. So that’s actually spiked to 40 percent chance of a rate cut this year and going back to the start of just this month, I mean it was in the single-digit. So, fairly low. But it became elevated fairly quickly and prior to the decline in markets at the end of q4, even in November you had a near zero percent chance of or zero percent probability of rate cuts in 2019 and now it’s nearly a coin flip at almost 50-50. So, keep an eye on that. Another notable market move as I said that move in the 10-year government bond yield, which actually inverted the curve just today which is on Friday. Which is something to really flag and keep an eye on. But the consensus really was for ten-year bond yields to increase pretty dramatically this year with the economic expansion. I believe consensus was well into the north of 3% range and now your sub 2.5% just going the wrong way. I mean they started March, early March north of 2.75%. So those have declined fairly sizable and if we look at the 1-day change in yields, this was actually the largest decline in yields with about 8 basis points was the biggest since summer 2018. So that’s pretty pretty sizable and other effects of this dovish statement and comments from the federal reserve here, I mean you had a big decline in the us dollar on that day is down 0.6%. The other thing that’s notable is U.S bank index really got punished this week just on the day of the fed announcement. It was down north of 3% and so when you have long-term bond yields coming down, that really compresses the profitability of banks and so their stockholders are not happy about these, what’s happening at the fed and what’s going on with the economy. Because it’s really, they’re really struggling to maintain their margins with it.
Mike: Yeah in terms of the banks they’ve been the one sector that really hasn’t responded in this 10-year recovery. They’ve been kind of struggling with low yield, so their net interest margins have been suppressed and yeah overall, they just haven’t reacted as much as some of you know tech sector, real estate things of that nature.
Julian: Yes, certainly if you look at the increase since the global financial crisis, in the U.S it’s really largely been driven by you know the technology names such as the Amazon, Apple, Alphabet, Netflix names such as those and if you look at say Citigroup and Bank of America, the other financial stocks, they really haven’t recovered. In comparing U.S stocks to global stocks and global stocks I believe are kind of where they were what 12 years ago. So, you’ve had this massive divergence between U.S. equities, specifically technology. Just because the S&P 500 is a much larger waiting in technology compare that to global stocks which have higher weightings of say financials, materials and there’s a big divergence there where you’ve had massive outperformance of U.S equities. So that’s something to watch and we’ll see if the U.S tech sector continues its leadership. But for now, what you’re seeing at the Fed and the yield curve certainly is not positive for the U.S. banking sector and so you know that’s something certainly to keep your eye on here as things progress and as we previously indicated the inversion of the yield curve, that’s a pretty big deal. So, we’ll keep our eye out for that and monitor how that progresses there.
So, we put out a blog post this week called The Danger of Return Targeting. I just wanted to dive a bit deeper into that. So, this post was spurred by an article in the Wall Street Journal this week that discussed CalPERS and some of their asset allocation decisions in a recent kind of policy meeting that they had. So what CalPERS is, it’s the California public employee’s retirement system. It’s a three hundred fifty-six-billion-dollar pension funds. So certainly one of the largest pension funds out there and the goal of a pension fund effectively is to earn sufficient returns that would satisfy the pension obligations of their constituents. So they made these promises, workers over time they contribute funds to the pension fund and the pension fund is supposed to earn sufficient returns to effectively pay them out enough throughout their retirement and so CalPERS has done the calculations and they believe that they need a seven percent return in order to satisfy those obligations and I put a pretty cool chart in the blog of how these allocations have changed over time. So, if we go back to 1995 when bond yields were significantly higher, if you had a pension fund that needed to earn seven and a half percent, you could satisfy that with a portfolio of 100% bonds and if you look at a portfolio that the bonds are typically the safest portion of a portfolio with the lowest standard deviation. So, if you look at the 1995 portfolio of hundred percent bonds, to get a seven-point five percent return that had a standard deviation, which is a standard measure of risk, of six percent. Now if we compare that same portfolio to 2015 to get that same seven-point five percent return, we had to replace eighty eight percent of those bonds with higher risk assets including stocks, real estate and private equity. Which had a standard deviation of nearly threefold or seventeen percent. So, this really highlights that pension funds and allocators to earn the returns that they used to be able to get relatively easily. They’re really going out on the risk spectrum to earn those and I just wanted to highlight a quote from the CalPERS chief investment officer here, he indicated that “We need private equity, we need more of it and we need it now” and so why do they need private equity? Well it’s to “Increase our chance of achieving the seven percent rate of return.” So to me that was a big red flag. They’re really just amping up the risk here in a desperate attempt to earn the required returns when perhaps the more prudent thing to do would be to perhaps increase funding of the pension plan. Decrease the promises to workers if possible. Understanding that they’re in a tight spot and that workers probably don’t want to put in more money and politically that’s always difficult to do and so looking at I wanted to transition looking at individual asset classes and if we look at another endowment’s asset allocation and so private equity is one of the riskiest portions of an institutional portfolio with standard deviation of almost twenty four percent. Now if we compare that to domestic equities at 18%, I mean that’s over 30 percent higher than U.S stocks and if we compare that to hedge funds with a standard deviation of about 8.6 percent, private equity is nearly triple the risk level of hedge funds and so CalPERS here looking to increase their allocations to private equity. But in my opinion, you know we’re kind of in the potentially peak of the second longest economic expansion on record, valuations are quite full. I read this week that private equity valuations in terms of go privates now exceed public multiples and so they’re really paying up. There is a lot of dry powder and private equity. A lot of allocators are looking at it like panacea that will solve all of their return issues going forward. But I just don’t think that that’s the answer. I don’t believe it’ll be that easy, how about you? What are your thoughts on it?
Mike: Yeah just mathematically that can’t be the case. If you’re acquiring companies for above market multiples, you know you can’t really expect to earn above market returns over the long term. But when we discuss you know looking at the risk side of the equation obviously needs to balance that with the return. So how can investor look at risk adjusted returns?
Julian: So, the easiest way to do that is to take standard deviation into account using those estimates and the difficult thing with private equity is you know you’re not marked to market and so they get a pass people tend to be oblivious to its volatility. Because they don’t get to check the accounts every day and see how it’s swinging around. But one thing that I wanted to mention is that private equity, the reason that it is more volatile than the broad stock market index is that private equity’s secret sauce is leverage. They use a lot of debt on their investments and that is you know the vast majority of their excess return, it just comes from more leverage, more debt on their investments and as you know debt amplifies returns. It amplifies them to the upside and also it amplifies losses to the downside. So certainly, I think when allocating capital, one must take into account risk-adjusted returns, take into account you know how much leverage you are utilizing here, what sort of standard deviation, what sort of risk and ultimately you know what’s your risk of losing money here. But you know ultimately if you’re running a conservative organization like a pension fund, I don’t necessarily think that private equity is the answer here. I think there are other levers to pull and relying on increased allocations to one of the most levered and volatile asset classes, one of the riskiest asset classes I think that’s ultimately a pretty risky proposition and ultimately it may not work well for them.
And that wraps it up ladies and gents for Episode 6 of the Absolute Return Podcast. Hope you enjoyed it. Be sure to tune in for next week and if you have any questions be sure to reach out on twitter, flip us an email and we’ll chat to you soon, cheers.
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