- From Disinflation to Disruption: The economy entered March on a moderating growth and disinflationary trajectory, but that backdrop shifted abruptly with the initiation of conflict in the Persian Gulf and the effective closure of the Strait of Hormuz. As a critical artery for global energy supply, this has driven a sharp increase in oil prices and renewed volatility across financial markets.
- Repricing Stagflation Risk: The initial impact has been a shift toward stagflation concerns. Higher energy prices have lifted short-term inflation expectations while simultaneously acting as a tax on consumers and businesses, and if sustained could tighten financial conditions and weigh on growth. This has complicated the policy outlook, as markets reassess the path of Federal Reserve easing amid renewed inflation uncertainty, reinforced by a stronger-than-expected March employment report.
- Timeline Matters: The duration of the disruption remains the key variable. What was initially expected to be a short-lived event now appears more likely to persist, increasing the risk that elevated energy prices and tighter financial conditions feed more meaningfully into economic activity.
- Uneven Global Impact: The economic burden is unlikely to be evenly distributed. Energy-importing regions, particularly across Asia and Europe, face greater exposure to sustained higher input costs and potential supply disruptions, while the U.S., as a more service oriented and energy independent economy, appears better positioned. While headline inflation may move higher in the near term, it remains less clear that these pressures translate into sustained core inflation, particularly if higher energy costs begin to weigh on demand.
- Slower Growth, No Recession: Our base case is that growth slows but remains positive, with the U.S. avoiding recession. The labor market remains stable in the near term, supporting income and consumption even as other areas soften. While higher energy prices function as a headwind, the U.S. economy continues to benefit from a service-oriented composition, lower reliance on imported energy, and ongoing business investment, including AI-related spending.
- Balanced Positioning, Selective Tilts: The shift from disinflation to disruption reinforces a diversified allocation near strategic targets. While uncertainty has increased, the absence of recession supports maintaining exposure to risk assets, with a preference for domestic equities given their relative insulation from the energy shock and stronger earnings visibility. Within fixed income, higher yields and improved compensation for interest rate risk support an increased emphasis on high-quality bonds as a source of income and portfolio stability.
- Counterintuitive Selloff: Rate markets experienced significant upheaval in March. Yields moved higher as rising oil prices lifted inflation expectations and drove a repricing of Fed policy. Treasuries declined alongside equities rather than acting as a haven, reflecting a market more focused on inflation risk than growth concerns. This repricing appears tied to near-term inflation expectations rather than a structural shift in underlying inflation fundamentals. Longer-term Treasuries led the way, while corporates underperformed as spreads widened modestly. Securitized sectors held up better given shorter duration and more stable cash flows.
- Slight Overweight to Duration: We moved our duration position to a slight overweight, bringing our interest rate sensitivity closer to that of the broad bond market. We view the recent rise in yields as creating a more attractive entry point, with current levels reflecting a repricing of near-term inflation risk that may prove temporary. This is not a call for recession or a move away from credit, but rather an incremental adjustment within a diversified portfolio. At current yield levels, duration offers improved income and a more balanced risk profile, with potential for price appreciation if growth moderates or inflation pressures ease.
- Focus on the Belly: Within rates, we continue to favor the intermediate portion of the curve. While long-end yields have moved higher, we view that shift as driven by a combination of near-term inflation uncertainty and structural pressures tied to persistent deficits, contributing to a higher term premium. In contrast, the intermediate portion of the curve offers more direct exposure to a potential shift in Fed policy while limiting exposure to long end structural pressures. Our modest overweight reflects a tilt toward the 7–10 year maturity segment, where we see the most attractive balance of income, roll-down, and risk-adjusted return potential.
- Fed Flexibility Amid Uncertainty: Fed policy remains a key anchor. While shorter-term headline inflation expectations have spiked, we do not expect a sustained acceleration in core inflation, as softer demand should limit broader price pass-through. Higher energy prices are likely to function as a headwind to growth, reinforcing the potential for policy flexibility over time. Improving productivity dynamics suggest the neutral rate may be higher, implying policy is less restrictive than current rate levels indicate.
- Attractive Entry Point: We view the recent rise in yields as creating a more attractive entry point for high-quality bonds. Markets appear to be placing greater weight on inflation risks while underappreciating the potential for growth to moderate, leaving yields elevated relative to underlying fundamentals. This creates a more favorable asymmetry for duration, where income is more compelling and downside risk from further yield increases appears more limited relative to the potential for yields to decline if growth slows or inflation pressures fade.
- Orderly Markets, Divergent Returns: Credit markets remained orderly in March despite hostilities in the Persian Gulf, with performance driven more by duration and technical factors than fundamentals. This reflects a late-cycle environment where returns are increasingly influenced by rates and positioning rather than broad-based credit improvement. Rising yields weighed on longer-duration investment grade corporates, while high yield
performed better thanks to their higher income and lower duration. Leveraged loans were the only major sector to generate positive returns, benefiting from minimal duration exposure and improved technical factors. - Oil Shock Impact: The oil price spike presents a sector-specific risk rather than a broad-based fundamental threat, particularly in a U.S. economy that is less energy intensive than in prior cycles. Higher energy costs function as a tax on consumers and margins but are more likely to pressure select industries than drive widespread credit deterioration. This reinforces a preference for sector differentiation and a bias toward higher quality.
- AI Disruption, Rising Dispersion: AI-driven disruption is increasing dispersion within technology sectors. While AI investment supports growth, it is also accelerating competitive pressures and business model disruption, particularly in software. This reinforces the importance of security level underwriting, especially in lower quality segments where business model risk is more pronounced. These risks remain more concentrated in leveraged loans and private credit than in public high yield bonds.
- Contained Spillover: Private credit stress is a risk, with spillover likely to emerge first in leveraged loans and lower-quality segments. Transmission is
most likely to occur through forced selling and tighter lending standards, rather than an immediate deterioration in fundamentals. Public high yield has structurally improved as lower quality borrowers have migrated toward private markets, suggesting broader contagion would require a more pronounced tightening in financial conditions. - K-Shaped Consumer: A K-shaped consumer continues to shape securitized credit outcomes, with divergence likely to widen as higher energy costs pressure lower-income borrowers. Securitized credit remains a preferred area of exposure, supported by structural protections and attractive relative value. The opportunity set is driven by dispersion, reinforcing the importance of underwriting discipline and deal level analysis.
- Constructive, Selective Positioning: We remain constructive on credit risk, supported by a still expanding economy and broadly stable fundamentals. However, spreads do not fully compensate for rising dispersion, geopolitical risk, and potential for tighter financial conditions, particularly in lower-quality segments. While all-in yields remain attractive, we favor higher-quality exposures, including investment grade and securitized credit, while maintaining a more cautious stance toward lower quality segments. We continue to view higher-quality high yield as a strategic allocation. Sector and security selection, combined with disciplined downside risk management, are expected to be the primary drivers of outcomes.
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.
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