arvest investment management group - march 2021 viewpoint
TRANSCRIPT
March | 2021
Viewpoint
Contact: 1 Clay Nickel ([email protected]) Alex Jantsch ([email protected])
Editor’s Note: There is no Taxable Bond Market section this month, as the Market Insights & Asset
Allocation and Federal Reserve Watch commentaries discuss the bond market.
- Market prices, and particularly interest rate
markets, typically provide an accurate
reflection of financial and economic realities
(Page 2), Today . . . there is a significant amount
of distortion, due in no small part to extreme
monetary policy accommodation by the Fed.
- FOMC is not just sitting on the Treasury and
mortgage bond markets, (Page 2), . . . This is
distorting inflation signals in addition to artificially
suppressing bond yields.
- Uncertainty bring us back to the things that
work in all markets (Page 3), proper asset
allocation, occasional rebalancing, and most
importantly, keeping emotions in check.
- We made additional upward revision to our
GDP growth estimates (Page 4), Our full year
2021 estimate is now 6.3% (previously 5.4%).
- The prospects for more rapid reopening and
re-engagement in “normal” economic activity
have improved (Page 4), A combination of past
relief and household savings have kept the
deleterious credit risks of economic scarring
mostly at bay.
- The monetary firehose is still wide open
(Page 8), Most of the Fed’s emergency
backstops have been removed, but the Fed is still
buying $80 billion of Treasury Securities and $40
billion of agency mortgage-backed securities
every month.
- Markets are “frothy,” (Pages 8), be it
cryptocurrency, collectibles, residential real
estate, certain commodity prices or certain
sectors of the stock market. . . .“irrational
exuberance”?
- The movement in Treasury yields certainly
got our attention last month (Page 8), . . . it
seems to us that this was simply a good, old
fashioned buyers’ strike, amplified by a messy
seven-year Treasury auction on the 25th.
- February was a strong month for equities
(Page 11), with the S&P providing a total return
of 2.76%.
- The prospect for strong inflation is
becoming more of a worry (Page 11), . . . M2
money supply has increased by 25% over the last
year, by far the fastest growth rate ever.
- the S&P is trading at very expensive
multiples (Page 12), which could cause big profit
taking at any time.
Asset Class Outlook
Equity Current Previous
U.S. Equity Slightly Unfavorable Slightly Unfavorable
Int’l Equity Neutral Neutral
Emer. Mkts Slightly Favorable Slightly Favorable
Fixed Income Current Previous
Invest. Grade Credit Slightly Unfavorable Neutral
Treasury/Agency Slightly Unfavorable Unfavorable
Mortgage Backed Unfavorable Slightly Unfavorable
Commercial MBS Slightly Favorable Slightly Favorable
High Yield Unfavorable Slightly Unfavorable
Emer. Mkts Debt Neutral Neutral
Taxable Muni Slightly Favorable
Tax-Exempt Unfavorable Slightly Unfavorable
TIPS Neutral Slightly Favorable
Real Assets Current Previous
Real Estate Slightly Unfavorable Slightly Unfavorable
Infrastructure Neutral Neutral
Commodities Slightly Favorable Slightly Favorable
Clay Nickel, CPM
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Fun House Mirrors Growing up a half-hour’s drive from Wichita, Kansas afforded an annual, early summer trip to a small, old, locally owned amusement park: Joyland! The kindly proprietor, Stanley Nelson, would reward area kids for good grades by reducing admission a bit for each “A”. All “A”’s would get you in for free plus the bonus of a congratulatory smile by Mr. Nelson, who insisted on working the admission booth during “grade days” promotions. For an eight-year-old, it was magical—the Whacky Shack thrill ride; the old, rickety, wooden roller coaster which we called the “widow maker;” the bumper cars, and the creaky, partially rusted Ferris wheel (potentially a widow maker as well, I suppose). These were mandatory, multiple times, for my friends and me. But on unseasonably warm days, we would take a break in the airconditioned fun house just long enough to test each curved mirror and get a chuckle at the distorted reflections. The point of this trip down memory lane? Market prices, and particularly interest rate markets, typically provide an accurate reflection of financial and economic realities. Today, while still reflective, there is a significant amount of distortion, due in no small part to extreme monetary policy accommodation by the Federal Reserve. Historically, we have used interest rate levels, the shape of the yield curve, real (inflation adjusted) interest rates, credit spreads, and Fed funds futures, among other indicators, to gauge market participants’ views of the economic and business environment. And while the more volatile stock market can be predictive as well, the reliability of the bond markets as a trusted signal was near absolute. Was. Today we have concerns about classic market signals. In the Federal Reserve section of this month’s Viewpoint Scott Phillips, Chief Investment Officer for Arvest Bank, details some of the specifics of the Federal Open Market Committee’s (FOMC) actions and bond markets and it is worth the time to read carefully. Beyond the details, a topic of our internal conversations this past week is whether interest rate signals can be trusted given the FOMC’s extreme accommodative actions; the 800-pound gorilla of the financial world, sitting on the tape. (Surely, we all know a variant of the old joke: where does an 800-pound gorilla sit? Wherever it wants!) And the gorilla is not just sitting on the Treasury and mortgage bond markets, but also soaking up an inordinate amount of Treasury Inflation Protected Securities (TIPS) as well. This is distorting inflation signals in addition to artificially suppressing bond yields. Fun house mirrors indeed. “Look at your head! It looks like a peanut! Wait, now it’s a pumpkin! And now a peanut again! Hahaha!” (Except that 40 years later, and applied to financial assets, the fun house effect isn’t a laughing matter.) At this time, it does not appear that the recent yield-yelp, pricing Treasury rates higher, was driven by realized inflation concerns. Instead, it could be better classified as “reflationary”—anticipatory of better economic growth ahead. Inflation? Reflation? Are we just making up words? What’s the difference? A simple rule of thumb, with thanks to American Century CIO, Rich Wiess, for succinct articulation, reflation is rising prices/rates back to normal, in other words, back to where they should be. Inflation is rising prices/rates above normal—above where they should be.
Clay Nickel, CPM
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But the key question remains, what are reliable market signals in an environment with an expanding Fed balance sheet, historically high stock valuation metrics, social media driven stock trading, and skyrocketing neoteric digital currencies? Candidly, there aren’t any. So we use what we have, skeptically, cautiously, and we attempt to parse signal from the noise with a realization that it could be in error. Of course, such uncertainty brings us back to the things that work in all markets: proper asset allocation, occasional rebalancing, and most importantly, keeping emotions in check. We won’t rehash these themes again this month but would point you to last month’s Viewpoint for more color. While we continue to recommend that investors whose portfolios have strayed from allocation targets to rebalance, we have not made any significant asset class allocation changes to our strategic model portfolios. Instead, we’ll close with a few quotes. One from a bestselling author, respected investor, and economist. One from a historian and politician of ancient Rome. And last, a favorite from a renowned market historian, savvy thinker, and publisher of the Grant’s Interest Rate Observer.
Just as no war plan survives contact with the enemy, no investment plan
survives contact with February. --John Mauldin
Truth is confirmed by inspection and delay; falsehood by haste and
uncertainty. --Tacitus
To suppose that the value of a stock is determined purely by a
corporation’s earnings discounted by the relevant interest rates and
adjusted for the marginal tax rate is to forget that people have burned
witches, gone to war on a whim, risen to the defense of Joseph Stalin and
believed Orson Welles when he told them over the radio that the Martians
had landed. -- Jim Grant
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Current Economic Snapshot
Quarterly & Fiscal Year GDP Growth (Average Annual)
Source 1Q21
(Forecast) 2Q21
(Forecast) 3Q21
(Forecast) 4Q21
(Forecast) FY21
(Forecast)
Bloomberg 3.5% 5.6% 6.2% 4.3% 4.9%
AWM/IMG 5.0% 9.5% 8.5% 4.3% 6.3%
Sources: Bloomberg, Bureau of Economic Analysis; Methodology: Average Annual Return
Investment Management Group’s Recession Indicators Indicator* Current Previous Short Term Trend Long Term Trend
CB Leading Econ. Indicators -1.5% -1.5% Positive Negative 3–Mon./10–YR. Yield Curve Spread +1.43 +0.84 Positive Positive
New Orders–to–Inventories 15.1 10.3 Neutral Positive
Cap. Goods New Orders +8.3 +11.1 Positive Positive
Initial Jobless Claims 730k 787k Neutral Negative
New Building Permits 1,881k 1,709k Positive Positive Sources: Bloomberg *See the Appendix for description of each indicator
G + I + C + NetX
We made an additional upward revision to our GDP growth estimates. Our full year 2021 estimate
is now 6.3% (previously 5.4%). Annualized quarterly estimates are as follows: 1Q—5.0% (2.5%
prev.), 2Q—9.5% (7.0% prev.), and we have added estimates for 3Q and 4Q of 8.5% and 4.3%
respectively. Candidly, these are astonishing growth figures (a number of respected economists
have growth estimates that are higher still). Yet, given the deep drop in economic activity in 2020,
it will still be late this year, possibly early 2022, before we are out of the hole and move from
recovery to true expansion.
Government Spending plus Busines Investment plus Consumer Spending plus Net Exports, or
total exports minus total imports (G+I+C+NetX) is the common equation for calculating U.S. GDP.
As vaccine production ramps up—it is estimated there will be enough vaccine made for every
U.S. adult by June—the prospects for more rapid reopening and re-engagement in “normal”
economic activity have improved. (The timetable for actual injections may be another matter, but
daily injection rates are increasing and should reach 2mm per day soon—a positive development.)
We have frequently cited the large cash-horde of U.S. households available for fueling further
economic growth. And honestly, most of us are ready to return to crowded restaurants, sporting
events, delayed vacations, large family reunions, etc., etc. So, there is ample pent-up demand to
accompany the capacity for U.S. households to spend. A win for the “C” in GDP math.
Additionally, government expenditures are set to ramp up as President Biden’s $1.9T recovery
and stimulus plan, or a slimmed down version still well above $1T, is poised for passage by mid-
March. A combination of past relief and household savings (there have not been the same
opportunities to spend during the pandemic) have kept the deleterious credit risks of economic
scarring mostly at bay. While there are still issues around employment and an uneven recovery,
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the additional government spending will add to U.S. GDP in 2021. Of course, it comes at the cost
of debt and the potential for slower growth in 2022 and beyond, but many investors consider that
a concern for another day.
Lastly, for those who think mathematically and can’t stand the idea of undefined variables,
business investment indicators are mixed. Generally, small company surveys for CapEx plans
are punkish, large business plans are generally positive, and the hodgepodge of regional Federal
Reserve Bank CapEx data are all over the map. U.S. net exports are always a drag since we,
notoriously, historically import more than we export. As decades long globalization trends stall,
and as supply chains are examined and likely strengthened, there could be some change to the
Net-X levels, but it is still a bit early to forecast with any certainty.
Purchasing manager indexes continue to signal strength––we will monitor this month’s slight
stumble in services/non-manufacturing ISM. There has been a marked improvement in COVID-
19 hospitalizations. The Kastle Back-to-Work barometer declined due to Dallas and Houston
experiencing abnormal winter weather—perhaps a gross understatement. Still, the figure
continues to be lackluster. The Mobility and Engagement index was also affected but is already
beginning to rebound to pre-storm levels.
Purchasing Managers Indexes
Source: ISM, Markit; Bloomberg; Copyright 2021 Bloomberg Finance L.P.
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The Global Vaccination Campaign
Source: Bloomberg News
COVID-19 Hospitalization Rates
Source: Bloomberg; Copyright 2021 Bloomberg Finance L.P.
Dallas Fed Mobility and Engagement Index
Source: Dallas Federal Reserve Bank; Bloomberg; Copyright 2021 Bloomberg Finance L.P.
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Kastle Back to Work Barometer
Source: Kastle Systems; Bloomberg; Copyright 2021 Bloomberg Finance L.P.
Clay Nickel Director of Investment Strategy | [email protected] Clay oversees and directs research, product line development, security selection and portfolio allocations. He is a keynote speaker, spokesperson for the portfolio management team, and a resource for Arvest Wealth Management’s investment officers and client advisors. A graduate of Wichita State University, Clay has completed Columbia University’s Academy of Certified Portfolio Management and is a member of the Chartered Financial Analyst Institute and Kansas City Society of Chartered Financial Analysts.
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Federal Reserve Watch: Too Much of a Good Thing
In the early stages of the pandemic, we urged investors not to become too pessimistic. The
Federal Reserve had slashed short-term interest rates to zero, was purchasing enormous
amounts of treasury and agency mortgage-backed securities, and was preparing facilities to
backstop and improve functioning in financial markets. Additionally, the U.S. Treasury was
queuing up large, successive COVID-19 relief packages that provided funding to support the
medical effort, direct payments to individuals, enhanced unemployment assistance, and funding
for small businesses. This tidal wave of monetary and fiscal stimulus softened the downside for
the economy and propelled asset and commodity prices higher.
Fast forward nearly twelve months into the future. The monetary firehose is still wide open. Most
of the Fed’s emergency backstops have been removed, but the Fed is still buying $80 billion of
Treasury securities and $40 billion of agency mortgage-backed securities every month. Fed
Chairman Jay Powell has given no indication that he expects to begin reducing (“tapering”) this
bond buying program in the near future. On the fiscal front, the Biden administration has proposed
(and the House of Representatives has passed) the $1.9 trillion American Rescue Plan that will
include $1,400 stimulus checks to most Americans (the third economic impact payment in the
past year), along with enhanced unemployment assistance, money to shore up state and local
governments, and what appears to be a long list of pork barrel spending items. Additionally, the
Biden administration is already talking about a roughly $2 trillion infrastructure spending package
as well.
The U.S. savings rate vaulted to 20.5% in January after the second economic impact payment
was received around year end. Wall Street economists are quickly revising economic growth
estimates higher for 2021, largely based upon falling COVID-19 infections, more rapid vaccine
distribution, and the prospects for some of households’ savings to translate into pent-up consumer
spending. Wall Street (and even certain parts of Main Street) seem to be giddy. Markets are
“frothy,” be it cryptocurrency, collectibles, residential real estate, certain commodity prices or
certain sectors of the stock market. Dare we utter the words of the ‘Maestro’ himself (from 1996):
“irrational exuberance”? Is it too much of a good thing?
It’s probably much too early in the cycle for bubble-bursting or fighting the Fed, but the movement
in Treasury yields certainly got our attention last month (and the Fed’s). Intermediate-term U.S.
Treasury yields, which had been quietly grinding higher since mid-summer as part of the reflation
trade, suddenly shot higher. The five-year Treasury note was hovering at 0.42% at the end of
January, but ended the month of February at 0.73% (after closing at 0.82% the day before month
end, nearly doubling the previous month end level). Similarly, the ten-year Treasury yield went
from 1.07% to 1.41% (kissing 1.61% intra-day on February 25). There are a lot of explanations
floating around out there, but it seems to us that this was simply a good, old fashioned buyers’
strike, amplified by a messy seven-year Treasury auction on the 25th. Bond investors envision a
whole lot of Treasury debt to be issued in the next few years in order to finance this deluge of
fiscal spending. And they also fear that the Fed will be less willing to buy this debt at some point,
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as the economy’s output gap closes and the threat of higher inflation looms. That day seemingly
got a little closer in the minds of bond traders last month.
5-Year Treasury Note Yield (blue) & 10-Year Treasury Note Yield (white)
Source: Bloomberg; Copyright 2021 Bloomberg Finance L.P.
Now, this is still “down the road” stuff, mind you. However, markets have certainly pulled forward
Fed tightening expectations from a 2024 event (which is what the Fed’s own projections still
indicate), to something more like a 2023 liftoff. Again, not much of a change, but it matters a lot
when the discount rates are this low (and risk assets are pricing in mostly good news).
Federal Reserve Fed Funds Rate Forecast (green) vs the Market’s (blue)
Source: Bloomberg; Copyright 2021 Bloomberg Finance L.P.
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As we mentioned above, it’s probably too early to get overly concerned. Indeed, we would not
be surprised if the Fed resurrects ‘Operation Twist’ in the near future – simultaneously buying
more intermediate and long-term Treasury notes and bonds (providing a ‘soft cap’ for term bond
yields), while selling (or buying less) short-term Treasury bills. This actually makes a whole lot of
sense right now (as market manipulations go), given that the next wave of fiscal spending is
likely to flood the banking system with deposits, bringing the strong possibility of negative short-
term interest rates for T-Bills and other overnight instruments. ‘Twist’ may be enough to calm
the savage beast that is the bond market, and bubble-bursting probably remains on the
somewhat distant horizon. Prudent risk managers should still keep an eye on the horizon,
however.
Scott Phillips, CFA Senior VP & Chief Investment Officer, Arvest Bank | [email protected] Scott manages Arvest Bank’s investment portfolio and is primarily responsible for the bank’s liquidity and funding, interest rate risk management and hedging, and loan and deposit pricing. He is a member of the Bank’s Asset-Liability Committee. He serves as a co-manager of the ABG Bond Fund, ABG Employee Benefit Bond Fund and ABG Government Bond fund. Scott manages a few separately managed fixed income portfolios for Arvest Bank’s Trust Division. He received a bachelor’s degree in economics & finance from Missouri Southern State University and a Master of Arts in economics from the University of Arkansas. Scott achieved the designation of Chartered Financial Analyst in 1990 and is a member of the CFA Society of Arkansas. He has been managing portfolios for Arvest since 1988.
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February was a strong month for equities with the S&P 500 providing a total return of 2.76% and
now sitting within 1% of its record high reached mid-February. The last week of February saw a
drop of 2.9%, but most of that was recovered on the first trading day of March. Stocks had been
rising for weeks before that drop due to slowing virus hospitalizations and deaths, and much
improved vaccine distribution.
The quick drop during the final week of February could just be rational profit taking, as the largest
drop was in the Nasdaq which had prior gains that outpaced every other index. But there are also
some concerns. The prospect for strong inflation is becoming more of a worry (although that would
hurt bond investments worse than equities). Retail sales and industrial production have improved
greatly over the last quarter, prices have risen, bond yields have increased, and the U.S.
government seems committed to a 3rd, larger stimulus than the prior two, whether it is truly needed
or not. Perhaps most concerning, Federal Reserve Chairman Jerome Powell does not believe
inflation matters or even exist at all, regardless of the money supply.
It is true that QE and TARP after the 2008-09 financial crisis did not have a major inflationary
impact. However, that money came in the form of bank reserves and did not really make it into
the “real” economy as evidenced by little change in the M2 money supply after those programs.
M2 money is the best gauge we have to forecast inflation and consist of real money such as
physical currency, checking deposits and small bank CDs (all money that is likely to be used
within the next year). The M2 money supply has increased by 25% over the last year, by far the
fastest growth rate ever.
Historical M2 Money Supply
GDP growth is improving and prices are increasing, especially in commodities like oil. The
increased worry of inflation has especially hurt bond prices, and increased bond yields. If this
trend continues and bond yields keep rising further, fixed income investments could become
competition for equities. This is more of a longer-term concern though, as the 10-year Treasury
yield is only about 1.5%, still considerably less than the 3% yield just 3 years ago. In fact, higher
long-term inflation is a reason to own equities and real assets over fixed income and cash.
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The economy in general has now entered into what is probably a multi-year recovery, with
corporate earnings strongly advancing over the next two years. However, the S&P 500 is trading
at very expensive multiples which could cause big profit taking at any time. We believe that this
would be the cause of a correction this year, rather than a problem with the economy or corporate
earnings.
Bret O’Meara Advisory Solutions Support Specialist | [email protected] Bret assists and support the management of investment portfolios through research, analysis, and trading of equity securities. He joined Arvest Wealth Management in 2010 as a member of the Retirement Plan Services Group before transitioning to the Investment Management Group. Bret has a BSBA in Economics and Finance and MBA, and taught courses in accounting and economics at Northwest Arkansas Community College for six years.
Christopher Magee Senior Equity Portfolio Manager | [email protected] Christopher is the lead manager of the Arvest Bank Group Equity Fund and the Investment Management Group DIG Equity Portfolio and is responsible for construction of equity portfolios for institutional and retail clients, including equity research, security selection, sector weightings and trading. Prior to joining Arvest Wealth Management in 1992, he served as a trust investment officer at a national bank in Shreveport, Louisiana and a bank in Amarillo, Texas. He has a BSBA in Finance, with an emphasis in investments, and is a graduate of Cannon Financial Institute’s Advanced Trust Investments School.
Ryan Ritchie Equity Portfolio Manager | [email protected] Ryan is co-manager of the Arvest Bank Group Equity Fund and co-lead manager of the Investment Management Group’s strategic portfolios and is responsible for the construction of equity portfolios for institutional and retail clients, including equity research, sector weightings, and trading. Additionally, he is responsible for directing the implementation of Arvest Wealth Management’s equity strategy throughout trust and brokerage relationships. Ryan has a BSBA in Finance with an emphasis in Financial Management.
Appendix Investment Management Group Team Members
Clay Nickel, Director of Investment Strategy Abbey Vibhakar, Fixed Income Analyst
Christopher Magee, Sr Equity Portfolio Manager Jake Baker, Fixed Income Analyst
Ryan Ritchie, Portfolio Manager Curtis Jones, Fixed Income Analyst
Dennis Whittaker, Sr Portfolio Manager Bret O' Meara, Advisory Solutions Support Specialist
Alain Monkam, Portfolio Manager Jennifer Tichenor-Turner, Adv Solutions Support Specialist
Kevin Woodworth, Portfolio Manager Jesica Campbell, Advisory Solutions Support Specialist
Alex Jantsch, Portfolio Analyst Charles Kurtz, Executive Assistant
Josh Warner, Portfolio Analyst
Description of IMG Recession Indicators
Conference Board Leading Economic Indicators (LEI) - The indicator tracks the Year-over-Year percentagechange in the Conference Board Leading Economic Indicators Index. The index is an American economic leadingindicator intended to forecast future economic activity. It is calculated by The Conference Board, a non-governmental organization, which determines the value of the index from the values of ten key variables.
U.S. Treasury Yield Curve (3-month to 10-year Spread) – This indicator measures the spread between the fixedincome yields of the 3-month Treasury Bill and the 10-Year Treasury Bond. The lower this number, the flatter theyield curve is. The flatter the yield curve is, the less longer term investors are getting compensated over shorterterm investors for the inherent interest rate risk. If the spread goes below zero, this means that the yield curve hasinverted.
ISM New Orders-to-Inventories Spread – This indicator looks at the spread of reported new order levels versusreported current inventories levels. The Institute for Supply Management (ISM) surveys 300 manufacturing firmson numerous manufacturing data points to get data points for both new orders and inventories.
Core Capital Goods (New Orders) – This indicator tracks the Year-over-Year percentage change in the value ofnew orders received during the reference period. Orders are typically based on a legal agreement between twoparties in which the producer will deliver goods or services to the purchaser at a future date.
Initial Jobless Claims – This indicator tracks the number of initial unemployment claims of people who have filedjobless claims for the first time during the specified period with the appropriate government labor office. Thisnumber represents an inflow of people receiving unemployment benefits.
New Building Permits – This indicator tracks the number of construction permits that have been issued andapproved for new construction, additions to pre-existing structures, or major renovations.
DISCLAIMER: These are not the only indicators that the IMG team looks at, and no decision should (or will) be made on any single indicator. These are simply what the IMG team utilizes to help forecast potential for a recessionary environment.
March | 2021
Disclosures Investment products and services provided by Arvest Investments, Inc., doing business as Arvest Wealth Management, member FINRA/SIPC, an SEC registered investment adviser and a subsidiary of Arvest Bank. Insurance products made available through Arvest Insurance, Inc., which is registered as an insurance agency. Insurance products are marketed through Arvest Insurance, Inc., but are underwritten by unaffiliated insurance companies. Trust services provided by Arvest Bank.
The Investment Management Group (IMG) is comprised of Arvest Wealth Management registered investment adviser representatives who provide portfolio management services with respect to certain of Arvest Wealth Management's investment advisory wrap fee programs (the "IMG managed programs").
Arvest Wealth Management does not provide tax or legal advice. Be sure to consult your own tax and legal advisors before taking any action that would have tax consequences.
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