Touchstone Asset Allocation Guidance

The markets stumbled, but the fundamentals didn’t. We take a closer look at the recent selloff, the growing debate around AI, and why we believe expectations, not earnings, have become the bigger risk.

By Touchstone Asset Allocation Committee

Allocation Update

Executive Summary

The markets have hit an AI speed bump. We believe this is largely a function of investor expectations for growth and AI adoption getting ahead of the fundamentals. For example, memory chipmaker SK hynix’s operating profit surged an astounding 557%, and somehow, that still wasn’t enough. Transformative technologies often follow a familiar pattern. Investors tend to overestimate the speed of impact, while underestimating the lasting effect they ultimately have on businesses and the economy.
Last month, it looked as though the prospects for reopening of the Strait of Hormuz were improving. Since then, expanding hostilities have weighed on markets and pushed energy prices higher, making a quick resolution seem unlikely. At the same time, Chair Warsh’s less-is-more approach to Fed communication has added another layer of uncertainty for investors.
Despite these headwinds, the broader earnings picture remains encouraging. Earnings continue to surprise, even across Europe. The U.S. consumer has remained resilient despite elevated fuel prices, and we are seeing positive news beyond AI, including healthy volume growth from Coca-Cola. We see recent market weakness as more of a stumble than a fall.

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Fixed Income

Weight: Moderate Underweight
We maintain moderate tactical underweight as we continue to see more attractive return opportunities in equities. While bond yields remain appealing, inflation risks and a less communicative Fed add uncertainty to the outlook.

Duration
Weight: Slight Overweight
We maintain a slight overweight to duration. While inflation risks have increased, today’s higher yields provide a more meaningful income cushion than in recent years, and we do not believe inflation pressures will be sufficient to drive a sustained rise in long-term yields.

U.S. Taxable Investment Grade
Weight: Neutral
We remain neutral on investment grade. Attractive yields and lower economic sensitivity continue to make high-quality corporate and securitized credit an appealing source of income and portfolio stability.

U.S. Taxable Non-Investment Grade
Weight: Moderate Underweight
We remain underweight high-yield bonds. Credit spreads remain near historic lows, while yield sits only modestly above historical averages, leaving little cushion should inflation remain elevated or economic growth begins to slow.

Equities

Weight: Moderate Overweight
We maintain a moderate overweight to equities, supported by resilient economic data and continued earnings strength. While AI remains the dominant market driver, we are beginning to see encouraging signs that earnings growth is broadening beyond AI-related companies.

U.S. Large Cap Blend
Weight: Moderate Overweight
Strong earnings growth and continued AI-related investment have supported equity markets. 2Q earnings are off to a very strong start, and forward estimates continue to move higher.

Growth
Weight: Neutral
We remain neutral on Growth. AI continues to be a powerful earnings driver, but expectations have also become increasingly demanding. Risks include delays in data center construction, slower-than-expected enterprise AI adoption, and AI's potential to disrupt existing business models.

Value
Weight: Neutral
The Value index contains a diverse mix of defensive, cyclical, and even growth-oriented companies that have migrated from Growth benchmarks. While we see attractive opportunities within the universe, we believe they are best captured through active management rather than passive.

U.S. Mid Cap
Weight: Slight Overweight
We maintain a slight overweight, supported by attractive valuations and improving earnings prospects. Within mid caps, we continue to favor high-quality companies with strong balance sheets and consistent cash generation.

U.S. Small Cap
Weight: Neutral
We remain neutral but continue to see reasons for increased optimism. Earnings revisions have improved, participation has broadened beyond AI beneficiaries, and rising M&A activity could provide an additional tailwind for valuations.

International Developed
Weight: Neutral
We remain neutral on developed international equities, though the outlook has improved modestly. Europe has been a relative laggard, but this earnings season has surprised to the upside and economic growth modestly exceeding expectations. We continue to believe active management offers the best opportunity to capitalize on the region's diverse opportunities and challenges.

International Emerging
Weight: Slight Underweight
We remain slightly underweight. With roughly 80% of the index concentrated in Asia, emerging markets remain sensitive to energy prices and external demand. In addition, significant exposure to the more commodity-like segments of the AI supply chain may contribute to higher volatility.

Strategic: Strategic asset allocation is a baseline allocation between asset classes established with a longer term focus and congruent with an investor’s investment goals and objectives. The allocation is meant to optimize the asset mix through methodical diversification in an attempt to maximize return and lessen risk.

Tactical: Tactical asset allocation is differentiated from strategic asset allocation by having a much shorter time horizon and the goal of adding alpha beyond what would be allowed through static strategic weights. Markets tend to be more volatile over shorter time horizons, while longer time frames tend to smooth out that volatility. That enhanced volatility in the short term creates the opportunity for either return enhancement and/or risk reduction by adding to or reducing weights of different asset classes.

About the Author

Touchstone Asset Allocation Committee

The Touchstone Asset Allocation Committee (TAAC) consisting of Richard “Crit” Thomas, CFA, CAIA – Global Market Strategist, Erik M. Aarts, CIMA - Vice President and Senior Fixed Income Strategist, and Tim Paulin, CFA – Senior Vice President, Investment Research and Product Management, develops in-depth asset allocation guidance using established and evolving methodologies, inputs and analysis and communicates its methods, findings and guidance to stakeholders. TAAC uses different approaches in its development of Strategic Allocation and Tactical Allocation that are designed to add value for financial professionals and their clients. TAAC meets regularly to assess market conditions and conducts deep dive analyses on specific asset classes which is delivered via the Asset Allocation Summary document. Please contact your Touchstone representative or call 800-638-8194 for more information.