- Growth Slowing, Still Intact: The latest GDP report confirmed that growth slowed in the fourth quarter, largely due to a temporary drag from government spending, while private demand held up. Consumer spending remained positive but moderated, particularly in goods, while AI-related capital expenditures continued to support nonresidential investment. Year-over-year growth has cooled meaningfully from its 2023 peak, but the economy continues to expand.
- Inflation Cooling, Not Conquered: Inflation continues to moderate, particularly in goods and shelter. However, core services ex-housing (“supercore”) remains uneven and wage-sensitive, keeping the disinflation path bumpy. CPI and PCE have delivered mixed signals, reinforcing that while the trend is improving, the last mile remains uncertain, especially amid renewed geopolitical risks to energy prices stemming from Persian Gulf hostilities.
- Selective Hiring Environment: Hiring has slowed as businesses digest the lagged effects of prior Fed tightening, ongoing trade and policy uncertainty, and potential AI-driven productivity gains. Recent job gains are increasingly concentrated in fewer sectors, suggesting breadth is narrowing. While layoff announcements persist, broad-based job losses have not materialized. The backdrop remains best described as “no hire, no fire.” Slower hiring does not yet signal systemic labor market stress.
- Supply Constraints Persist: Slowing population growth and potential net negative immigration represent meaningful supply-side constraints. A tighter labor supply can limit sharp increases in unemployment even as hiring cools. That said, friction is inevitable as workers and firms adapt to evolving trade dynamics, technological change, and shifting industry demand. Structural forces are playing a larger role in shaping the labor backdrop than in prior cycles.
- AI Investment and Reacceleration Potential: AI adoption is accelerating, driving capital spending in infrastructure and productivity-enhancing technologies. While concerns about labor displacement have grown, AI-related investment is also a tangible source of economic support. The economy continues to expand north of 2%, and expectations for sustained AI investment into 2026 provide a credible pathway for renewed momentum.
- Constructive but Vigilant: Growth has moderated but remains positive. Inflation is easing but still sticky. Labor markets are cooling yet stable. Geopolitical risk, trade uncertainty, and structural adjustment warrant caution, but economic activity holding above 2% alongside emerging investment tailwinds supports a balanced asset allocation approach.
- Slight Overweight to Duration: The Committee has shifted from neutral to a slight overweight in duration, moving portfolios incrementally closer to the duration of the Bloomberg U.S. Aggregate Bond Index. While we continue to expect resilient U.S. growth in 2026, the balance of near-term risks supports tactically extending duration modestly.
- Rates Rise, Ballast Role Intact: In a counter-intuitive move, Treasury yields rose sharply following the escalation in the Middle East, as markets priced higher oil and fewer near-term Fed cuts. While energy spikes may lift headline inflation temporarily, we do not see sustained pass-through into core prices. Despite the backup in yields, high-quality fixed income continues to serve as portfolio ballast and could benefit if growth expectations soften or risk sentiment deteriorates.
- Curve Dynamics – Tactical Forces in Play: Structurally, 5%+ nominal GDP growth and persistent fiscal pressures should keep long rates biased higher. Near term, however, flight-to-quality flows, investors covering underweight positions at the long end, and softer labor data are likely to pressure yields lower. We prefer the intermediate portion of the curve for its attractive roll-down and balanced risk profile, while recognizing that risk-off episodes can produce outsized gains at the long end.
- Fed on Hold, Policy Trade-Offs Intensify: The Fed remains on pause, with markets pricing possible easing later in 2026, even as minutes revealed discussion of potential hikes. A return to $100 oil complicates the outlook—lifting headline inflation while acting as a tax on consumers and pressuring growth. This tension increases uncertainty around the Fed’s reaction function and may keep volatility elevated across the curve. Importantly, with the policy rate still elevated, the Fed retains room to accommodate further rate cuts should economic conditions warrant easier policy.
- Flexibility Matters: With growth still expected to expand in 2026, supported by AI-related investment and solid private balance sheets, we are not positioning for contraction. However, in an environment where sentiment can shift quickly, active management of duration and curve exposure is essential for capital preservation and opportunity capture.
- Defaults Drifting Higher, Still Contained: Default rates have edged up from cyclical lows but remain below long-term averages. Forecasts call for only modest increases, consistent with normalization rather than systemic stress. Leverage is manageable for most issuers and interest coverage remains adequate. Credit conditions remain stable overall, though dispersion is rising as AI-driven disruption differentiates winners and losers.
- Spreads Widen, Returns Diverge: Spreads widened modestly in February, with more pronounced moves in corporates, high yield, and bank loans. Importantly, both IG and HY bonds generated positive total returns, supported by income. Bank loans lagged and underperformed as floating-rate tailwinds faded and idiosyncratic risks increased. The environment increasingly favors active security selection over broad beta exposure.
- Risk Migration Supports Public Bond Quality: Smaller, less creditworthy issuers have migrated over time toward leveraged loans and private credit, improving the average quality of the public high yield bond market. Software exposure remains a relatively small share of the HY bond index compared with its larger footprint in loans and private credit, suggesting AI-related disruption risk is more concentrated outside traditional public bonds.
- Securitized Credit and a K-Shaped Consumer: Securitized credit fundamentals remain generally constructive. Household balance sheets are strong in aggregate, though the consumer remains increasingly K-shaped, with lower-income cohorts under greater strain. Underwriting discipline and structural protections have helped contain deterioration, but dispersion warrants continued selectivity.
- Geopolitical Risk and Tactical Opportunity: Rising Middle East hostilities have introduced episodic volatility, often transmitted through energy prices and safe-haven flows. Historically, unless conflicts materially disrupt global growth or supply chains, spread widening tied to geopolitical shocks has tended to be temporary. An oil price spike would pressure energy-sensitive sectors but could benefit exploration and production issuers within corporate credit. Such periods can create attractive entry points for disciplined active managers prepared to deploy capital selectively.
- Positioning: Quality Bias, Selective Risk: We maintain a full allocation to fixed income with a tactical overweight to U.S. investment grade and a moderate underweight to below-investment-grade credit. While income remains supportive, tight spreads and rising dispersion reinforce our preference for higher-quality exposure and active management within credit markets.
Fixed Income Indexes Characteristics
The Indexes mentioned are unmanaged statistical composites of stock market or bond market performance. Investing in an index is not possible.
For Index Definitions see: TouchstoneInvestments.com/insights/investment-terms-and-index-definitions
2024 – Economic growth continued unabated, driven by consumer spending. Inflation moderated further. The Federal Reserve pause continued until September, after which it cut interest rates three times by a total of 1 percentage point. Bond yields rose in response, resulting in only modest gains for high quality fixed income but better returns for riskier areas of fixed income.
2025 – The economy remained resilient, and inflation stayed sticky, keeping yields elevated but allowing high-quality intermediate maturity bonds to generate solid returns as the Fed cut rates late in the year. Steady growth and improving liquidity supported tighter spreads, driving performance in credit-sensitive areas of the fixed income market.
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, LLC*
*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
