Asset Allocation Chart of the Month
Rate Cuts Likely to Benefit Small Caps
- Chart. The Fed restarted cutting rates in September. We don’t see a U.S. recession on the horizon. Historically, rate cuts that occur while the economy is expanding have supported equities. Looking back to the early 1980s (the start of our return series), we identify five non-recessionary easing cycles. On average over those cycles, the Russell Top 200 Index returned 15.8% and the Russell 2000 returned 15.4% in the subsequent 12 months. The averages are similar, though the outcomes varied by cycle and small caps were positive in each case.
- Positioning change. We removed our small cap underweight as the Fed began cutting again, though it was not just rate cuts that attracted us back to small caps.
- Earnings trend. After two years of steady downward revisions, small cap EPS estimates stabilized about five months ago despite softer economic growth and tariff uncertainty, suggesting that the worst may be past. Consensus now expects small cap EPS growth to outpace the S&P 500 in 2026.
- Cyclical linkage. Small caps tend to track industrial production, which should benefit from tariffs and OBBBA-related capital expenditure tax incentives in 2026 and beyond.
- Valuation. Small caps are the only major U.S. equity asset class trading below their 30-year median valuation range (based on the S&P 600 index).
- Sentiment. NFIB small business survey readings have turned more optimistic.
- Quality tilt in cutting cycles. According to BofA’s U.S. SMID Cap Strategist, rate-cutting cycles tend to favor higher-quality small caps. Notably, the S&P 600 index (which excludes non-earners) has recently underperformed the Russell 2000 by over two standard deviations. This rare divergence has occurred only twice in the past 20+ years, and in both cases the higher-quality S&P 600 index rebounded strongly.
- Conclusion. We believe the backdrop for small caps warrants consideration for investors who are looking for diversification and potential outperformance.
The Touchstone Asset Allocation Committee
The Touchstone Asset Allocation Committee (TAAC) consisting of 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 are delivered via the Asset Allocation Summary document. Please contact your Touchstone representative or call 800.638.8194 for more information.
A Word About Risk
Fixed-income securities can experience reduced liquidity during certain market events, lose their value as interest rates rise and are subject to credit risk which is the risk of deterioration in the financial condition of an issuer and/ or general economic conditions that can cause the issuer to not make timely payments of principal and interest also causing the securities to decline in value and an investor can lose principal. When interest rates rise, the price of debt securities generally falls. Longer term securities are generally more volatile. Investment grade debt securities may be downgraded by a Nationally Recognized Statistical Rating Organization to below investment grade status. Non-investment grade debt securities are considered speculative with respect to the issuers' ability to make timely payments of interest and principal, may lack liquidity and has had more frequent and larger price changes than other debt securities. Equities are subject to market volatility and loss. Growth stocks may be more volatile than investing in other stocks and may underperform when value investing is in favor. Value stocks may not appreciate in value as anticipated or may experience a decline in value. Stocks of large-cap companies may be unable to respond quickly to new competitive challenges. Stocks of small- and mid-cap companies may be subject to more erratic market movements than stocks of larger, more established companies. Investments in foreign, and emerging market securities carry the associated risks of economic and political instability, market liquidity, currency volatility and accounting standards that differ from those of U.S. markets and may offer less protection to investors. The risks associated with investing in foreign markets are magnified in emerging markets, due to their smaller and less developed economies.
The information provided reflects the research and opinion of Touchstone Investments as of the date indicated, and is subject to change without prior notice. Past performance is not indicative of future results. There is no assurance any of the trends mentioned will continue or forecasts will occur. Investing in certain sectors may involve additional risks and may not be appropriate for all investors. The indexes mentioned are unmanaged statistical composites of stock or bond market performance. Investing in an index is not possible. For Index Definitions see: TouchstoneInvestments.com/insights/investment-terms-and-index-definitions
Please consider the investment objectives, risks, charges and expenses of the fund carefully before investing. The prospectus and the summary prospectus contain this and other information about the Fund. To obtain a prospectus or a summary prospectus, contact your financial professional or download and/or request one on the resources section or call Touchstone at 800-638-8194. Please read the prospectus and/or summary prospectus carefully before investing.
Investment return and principal value of an investment in a Fund will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. All investing involves risk.
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