- We are maintaining a neutral stance on large cap blend equities. We see near term risks for the market, though absent a recession, we don’t see conditions for a bear market.
- We expect market volatility to increase this fall, with both upside and downside risks increasing. September has historically been the weakest month for the S&P 500, and a correction is possible. Still, looking towards 2026, we see several positives that temper the downside case.
- Our forecast has called for slower economic growth in the second half, and recent data support this view. The past two employment reports fell well short of expectations and align with weaker survey data. Importantly, softer labor conditions appear to stem more from slower labor force growth, driven by immigration and tariff policies, than from layoffs, which would be more concerning.
- We expect the Fed to restart cutting rates in September at a gradual pace. Historically, mid-cycle rate cuts are positive for stocks, but we must weigh how much has already been priced in (U.S. stocks have set more than 20 all-time highs this year) and whether the cuts will prove to be as stimulative as expected; we have our doubts, given the apparent lack of economic rate sensitivity over the last couple of years.
- 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 stocks. They will be needed to offset continued headwinds from tariffs and slowing labor force growth.
- 2Q S&P 500 earnings growth came in much better than expected, up ~13% year/year. However, only three sectors had greater earnings growth than the S&P 500. Tech and AI-related companies continue to be the main story for market earnings. Looking forward, earnings growth for stocks outside of the Technology sector are expected to accelerate, and earnings revisions for the remainder of the year are beginning to move higher.
- We tactically hold a moderate underweight in Growth and remain neutral on Value.
- The growth underweight reflects both high valuations and concentration risk. Just five stocks now make up 46% of the Russell 1000 Growth Index. These stocks are heavily tied to AI, leaving index performance highly dependent on AI.
- So far, the AI story has been about model progress and capacity expansion, and it has been dramatic. Bloomberg estimates that 1H real GDP growth of 1.4% would have been closer to 0.4% without AI-driven investment. Much of this spending is to meet strong demand. We believe that the adoption of AI will continue to grow rapidly, and its economic impact will broaden. According to FactSet, AI mentions during S&P 500 earnings calls jumped up 32% from the prior quarter. By sector, mentions of AI increased the most for Financials and Industrials. These two Value sectors are among the most likely to be impacted by AI, given that the work is repetitive, data rich, high volume, and rules based.
- While we are bullish on AI, we believe that AI stocks already reflect a bullish outlook, but that doesn’t mean they can’t continue to rally. Over the next couple of years, we envision three distinct paths for AI and the markets, two of them suggest a broadening of market returns beyond the current AI stalwarts.
1. Broad Productivity Gains: AI lowers costs across industries, extending benefits beyond today’s leaders.
2. Cost of Doing Business: AI adoption becomes essential but is mostly a cost of doing business needed to stay competitive. While there is likely to be some productivity gains, the main beneficiaries remain the owners of AI technology. While there will be winners from applying AI technology, returns are likely to be more dispersed beyond the current leaders.
3. Slower Model Progress: AI use continues to grow, but not to the extent needed to support many of the valuations seen in the AI leaders. - Another risk for Growth is a potential loss of Fed independence, which could push long term rates higher, pressuring Growth stocks, given
they are longer-duration assets.
- We favor mid caps over small caps, which we see as offering the best risk/reward balance in the current market.
- Both segments outperformed in August on rising expectations for a September rate cut, with small caps posting the strongest gains. That said, we remain cautious about the durability of small cap outperformance given their higher economic sensitivity to economic conditions and our lack of conviction in a meaningful economic rebound. Assuming the Fed maintains its independence, we expect the rate cutting cycle to be gradual and only modestly supportive for growth. Still, lower rates should provide some relief, and sentiment among small business CFOs has been improving. Our view on small caps is not negative – only that, as with all investing, our views are relative to other investment opportunities.
- Historically, small and mid cap indexes traded closely, but that relationship has decoupled over the past 5 years as mid-caps outperformed. Several factors help explain this shift:
Structural & Sector Differences: Mid caps have greater exposure to Industrials, Tech, and Health Care, sectors that have benefited from both structural and cyclical tailwinds. Small caps are more heavily weighted toward low-growth cyclicals and financials, which are struggling amid rate volatility and tighter credit. This sector tilt gives mid caps a higher exposure to quality and growth factors
Superior Profitability & Financial Strength: Mid caps now exhibit operating margins and ROEs that are nearly double those of small
caps, an important divergence from the pre-2019 norm.
- In terms of sector diversification and profitability, Mid caps are increasingly resembling the equal-weighted S&P 500, yet they continue to trade at a discount. We believe that mid caps may offer a compelling substitute for broad large-cap exposure, particularly for investors seeking diversification, quality, and valuation.
- In a slower growth economy with uncertain policy direction, we believe mid caps offer a more attractive balance of opportunity and risk. While small caps may outperform in a sharp recovery or aggressive Fed easing cycle, we believe mid caps present a better quality-for-risk tradeoff in the near term.
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
