- We are maintaining a neutral stance on large cap blend equities as we see a more evenly balanced market environment. However, with visibility limited and valuations stretched in parts of the market, our conviction levels remain low. We believe steady positioning and selectivity are warranted.
- Given how extended parts of the market have become, we expect continued volatility, with both upside and downside risks. However, looking towards 2026, several positives help temper the downside case.
- Our near-term economic outlook has improved following stronger-than-expected GDP growth in the 2Q, which appears to have continued into the 3Q. The economy, like the market, has been bifurcated, with lower-income consumers showing signs of strain, while higher-income consumers (who account for a greater portion of spending) have remained resilient.
- The Fed restarted rate cuts in September, and we expect additional cuts, albeit at a gradual pace. Historically, mid-cycle rate cuts have supported equities, but the key questions are how much of this is already priced in and whether the cuts will prove as stimulative as expected. We remain cautious on that point, given the limited rate sensitivity the economy has shown in recent years. This is not necessarily a negative, as AI spending, currently the main economic driver, is not interest rate sensitive.
- Looking ahead to 2026, a more accommodative Fed, tax cuts from the One Big Beautiful Bill, the World Cup, and the 250th anniversary celebrations should provide some tailwinds for equities. These will be needed to offset headwinds from tariffs and slowing labor-force growth.
- The 3Q earnings season should bring greater visibility into demand trends and how effectively companies have passed through tariff-related costs. Earnings growth outside the Technology sector is expected to accelerate, and earnings revisions for the remainder of the year are beginning to move higher, albeit modestly.
- We tactically hold a moderate underweight in Growth and remain neutral on Value.
- Our underweight in Growth reflects both elevated valuations and concentration risk. Just five stocks make up 45% of the Russell 1000 Growth Index. These names are heavily tied to AI, making index performance highly dependent on that theme and increasing stock-specific risk. Our positioning allows us to manage those risks, while still participating.
- The AI story remains compelling, driven by rapid model progress and capacity expansion to meet strong demand. We believe that AI adoption will continue to grow quickly, with its economic impact extending well beyond the Technology sector – similar to the evolution of the internet. Sectors such as Financials and Industrials are among those most likely to benefit, given their repetitive, data-rich, high-volume, and rules-based workflows.
- While we are bullish on AI’s long-term potential, valuations already reflect a highly optimistic outlook. That doesn’t preclude further upside, but the risk/reward balance has become more asymmetric. Over the next few years, we see three possible paths for AI and market leadership. We have ordered these by our probabilistic expectation
1. Broad Productivity Gains: AI lowers costs and boosts efficiency across industries, extending benefits beyond current leaders.
2. Cost of Doing Business: AI adoption becomes essential for competitiveness, but is mostly a cost of doing business. While there is likely to be some productivity gains, the main beneficiaries remain the current leaders. While there will be winners from applying AI technology, returns are likely to be more dispersed.
3. Slower Model Progress: AI adoption continues but fails to meet lofty expectations, and the massive capacity plans in place look excessive. This path would likely entail a bear market with current winners turning into losers. - Looking forward, Growth stocks continue to offer the greatest opportunity and risk, though today that risk is unusually concentrated. Value stocks, meanwhile, are more tied to economic conditions and could benefit if growth picks up next year. While we see this potential, meaningful headwinds temper our optimism.
- We favor mid caps over small caps, viewing them as offering the most attractive risk/reward balance in the current market.
- That said, we have removed our small cap underweight as the Fed returned to rate cuts, as well as a number of other factors
- After two years of steady downward revisions, small cap EPS estimates have stabilized over the past five months despite softer growth and tariff uncertainty—suggesting that the worst may be behind us. Consensus now expects small-cap EPS growth to outpace the S&P 500 in 2026.
- Small caps tend to track industrial production, which should benefit from tariffs and OBBBA-related capital expenditure tax incentives in 2026 and beyond. Early signs of an upturn in manufacturing new orders support this outlook.
- Small caps remain the only major U.S. equity segment trading below their 30-year median valuation range (based on the S&P 600 index).
- NFIB small business surveys show a notable uptick in optimism.
- When rate cuts occur outside of a recession, higher-quality small caps tend to outperform. Notably, the S&P 600 (which excludes non-earners) has recently underperformed the Russell 2000 by more than two standard deviations—a divergence that has occurred only twice in the past 20+ years, and was followed by strong S&P 600 index rebounds.
- These factors suggest the backdrop for small caps is improving, making them worth consideration for investors seeking diversification and potential outperformance.
- Earnings growth in 2026 for both small and mid cap indexes is expected to match or surpass the large-cap growth index. Is this a reasonable expectation? Small cap earnings have been in decline for the last 3 years, which creates a very low bar. However, given current valuations, we believe that even half the anticipated growth would be taken positively by investors.
Equity Indexes Characteristics
The Indexes mentioned are unmanaged statistical composites of stock market or bond market performance. Investing in an index is not possible.
Glossary of Investment Terms and Index Definitions
Source: Bloomberg. Percent ranks are based on 30 years of monthly data as of the end of July; EPS growth estimates based on consensus bottom-up analyst estimates
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
Investing in fixed-income securities which 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 which may be downgraded by a Nationally Recognized Statistical Rating Organization (NRSRO) to below
investment grade status. U.S. government agency securities which are neither issued nor guaranteed by the U.S. Treasury and are not guaranteed against price movements due to changing interest rates. Mortgage-backed securities and asset-backed securities are subject to the risks of prepayment, defaults, changing interest rates and at times, the financial condition of the issuer. Foreign 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. Emerging markets securities which are more likely to experience turmoil or rapid changes in market or economic conditions than developed countries.
Performance data quoted represents past performance, which is no guarantee of future results. The investment return and principal value of an investment in the Fund will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be higher or lower than performance data given. For performance information current to the most recent month-end, visit TouchstoneInvestments.com/mutual-funds.
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.
Touchstone Funds are distributed by Touchstone Securities, Inc.*
*A registered broker-dealer and member FINRA/SIPC.
Touchstone is a member of Western & Southern Financial Group
Not FDIC Insured | No Bank Guarantee | May Lose Value
