- We believe the case for an economic soft landing has increased on continued labor market strength, inflation trending towards the Federal Reserve’s 2% target, and economic growth exceeding expectations. A soft landing suggests a new bull market started in October 2022. However, it has been a unique start as characteristics typical of a market recovery (e.g., value leading growth, small-caps leading large-caps, strong market breadth, and low quality outperforming high quality) have been absent.
- Despite a more favorable picture, large caps have vulnerabilities, and we are slightly underweight the asset class. Valuations are high by historical standards, regardless of the lens, and the largest companies continue to have outsized valuations.
- We believe economic growth will slow in 2024 due to the lagged effects of high interest rates. ISM readings appear to be bottoming out but remain at levels associated with economic softness. Recent economic data has been strong and may prevent the Fed from cutting interest rates as quickly as the market is expecting (or hoping).
- As earnings season started in January, reported earnings were running below expectations but as more companies reported and surprised to the upside, especially large technology companies, the picture became stronger. We believe expanding profit margins are consistent with improved productivity and may support valuations.
- In December we increased our Value stock exposure and reduced Growth, to lessen exposure to the extended Magnificent 7 (Nvidia, Apple, Meta, Microsoft, Tesla, Amazon, and Alphabet) and in anticipation of a more economically friendly monetary policy. The Magnificent 7 generally reported strong Q1 earnings and most have seen their lofty forward P/E ratios decline slightly.
- After its January meeting the Fed stated its next move was likely a cut in interest rates, which historically benefits economically sensitive Value stocks. Our allocation shift was modest as we see near-term economic risk, and Value stocks as measured by the index are not that attractive relative to their own history. That said there is a wide divergence among individual stock valuations suggesting an active approach may benefit.
- Growth stocks have outperformed Value year-to-date on favorable earnings reports and are expected to have twice the earnings growth as Value in 2024. However, Value sectors such as Energy, Health Care, Industrials, and Utilities have had stronger upside earnings surprises so far this earnings season.
- Growth is expensive by multiple definitions on a historical basis, a reflection of expectations to provide protection in uncertain economic conditions, as well as a heavy influence of the Magnificent 7. These companies represent approximately 25% of the S&P 500, 46% of the Russell 1000 Growth, and 52% of the S&P 500 Growth indices.
- Year-to-date mid- and small-caps significantly lagged large-caps. Small companies were challenged on two fronts. In recent weeks concerns of commercial real estate problems cast a pall over smaller financial companies at the same time interest rates increased, which impacts small-caps due to heavier reliance on floating rate financing structures.
- We remain overweight mid- and small-caps as current valuations are low relative to their own histories and at levels historically associated with recessions. In the decade before the pandemic earnings and stock prices for small-caps relative to large-cap moved together. In recent years, a gap has formed as large-cap earnings were weaker and yet their stock prices surged. We expect the gap to narrow over time, which will result in stronger relative returns for small caps.
- Using the S&P indexes, small- and mid-cap earnings in 2024 are forecast to reverse from an 11% decline in 2023 to a 7% gain. We see these estimates as reasonable, if not conservative, and well discounted in current valuations.
- We believe small caps have the potential to outperform, but investors should be cautious about implementation as stark differences remain between high and low-quality stocks. The Russell 2000 Index is considered lower quality as approximately 30% of its constituents are not earning enough to cover interest expenses, and 41% have negative EPS. The S&P indexes exclude unprofitable companies. However, the higher quality S&P 600 Index is historically much cheaper on a number of valuation measures than the Russell 2000 Index.
Equity Indexes Characteristics
The Indexes mentioned are unmanaged statistical composites of stock market or bond market performance. Investing in an index is not possible.
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 Brian Cheyne, CFA, CIMA - Senior Investment Strategy Specialist, 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