Asset Allocation Chart of the Month
Potential Headwinds for Risk Assets
- Bullish Sentiment: Consensus strategist forecasts call for double-digit S&P 500 returns, and positioning suggests investors are largely on board. A November Bank of America (BofA) survey shows portfolio managers holding one of the lowest cash allocations in modern history, while AAII data also reflect elevated bullishness and historically low cash balances. While not a definitive signal, this backdrop suggests bad news may be more impactful.
- AI Disappointment Risk: AI has been the dominant market and economic driver, making it the most consequential risk for investors. Any stumble could have broad repercussions. Potential disappointments include an inability by model builders to demonstrate pricing power. Competitive moats remain thin, and switching costs are low. Meanwhile, Chinese open source models now lead global adoption, offering a low-cost alternative to closed systems. A major enterprise shifting from a proprietary to an open source model, or the emergence of a compelling app built on open architecture, could challenge prevailing AI valuation assumptions.
- Too Much of a Good Thing: The combination of rate cuts and fiscal stimulus could reignite demand and inflation, forcing the Fed to pivot from market friend to foe. In such a scenario, the risk of renewed tightening would rise. A rebound in inflation could also push the U.S. dollar higher, weighing on international returns for U.S.-based investors.
- Small Businesses Sagging: Stress among small businesses is becoming more visible. Small business bankruptcies increased dramatically in 2025. Small business optimism dropped to a six-month low, driven by a deteriorating earnings outlook. While broad measures of credit conditions look loose, smaller businesses are having a harder time accessing credit, with falling approval rates. BofA's small business payment data also shows slowing hiring and a greater reliance on credit cards. The risk is that these pressures spread to larger companies.
- Consumer Concerns: Two risks stand out. First, relates to weakening employment conditions with rising layoffs spurring rising unemployment (especially for college graduates), and rising delinquencies. Second, while upper-income consumers are less economically exposed, they are increasingly market-exposed. A meaningful equity drawdown could erode the wealth effect and reduce overall consumer resilience.
- Debt Supply Glut: As M&A heats up and data center funding shifts toward debt markets, net new issuance could exceed $2 trillion in 2026, double the average of the last 25 years. Is there enough appetite for all of this debt? If not, credit spreads could widen, and the term premium on longer-term debt could rise, even in the face of rate cuts.
- The Election Cycle Volatility: Historically, the second year of a presidential term (the mid-term year) has been the weakest of the four. This is based on an average, and there are enough outliers to question the usefulness of this data point. Yet we can say that historically, the mid-term year tends to be more volatile, as two-thirds of the time the market has drawn down more than 15% during the year (since the 1930s).
Market Risks Summary
– Michael de Montaigne
For investors, risk is inherently two-sided. There are both upside and downside risks. It is also important to understand that risk is not what will happen, but what could happen. There is always an abundance of risks for investors to consider, and human nature tends to focus disproportionately on the negative. This is why the markets are often said to climb a wall of worry.
Most investors instinctively associate risk with falling prices rather than rising ones. Yet, rising prices tend to be the biggest risk for longer-term investors, as fears of losing money can lead to underinvestment at times.
The current economic environment is unusually difficult to forecast. As we have shown, it is possible to construct a compelling case for both optimism and caution using credible data. While we currently lean bullish, we felt it was important to fully examine potential headwinds, ensuring these risks remain evident and that we are prepared to adjust course if needed.
Taken together, this framework reflects how we approach markets: not with absolute certainty, but with awareness. History reminds us that markets have typically rewarded patient investors over time, even amid uncertainty. With that perspective, we wish you a healthy, prosperous, and market-friendly new year.
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
Fixed-income securities 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 may be downgraded by a Nationally Recognized Statistical Rating Organization to below investment grade status. Non-investment grade debt securities are considered speculative with respect to the issuers' ability to make timely payments of interest and principal, may lack liquidity and has had more frequent and larger price changes than other debt securities. Equities are subject to market volatility and loss. Growth stocks may be more volatile than investing in other stocks and may underperform when value investing is in favor. Value stocks may not appreciate in value as anticipated or may experience a decline in value. Stocks of large-cap companies may be unable to respond quickly to new competitive challenges. Stocks of small- and mid-cap companies may be subject to more erratic market movements than stocks of larger, more established companies. Investments in foreign, and emerging market 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. The risks associated with investing in foreign markets are magnified in emerging markets, due to their smaller and less developed economies.
The information provided reflects the research and opinion of Touchstone Investments as of the date indicated, and is subject to change without prior notice. Past performance is not indicative of future results. There is no assurance any of the trends mentioned will continue or forecasts will occur. Investing in certain sectors may involve additional risks and may not be appropriate for all investors. The indexes mentioned are unmanaged statistical composites of stock or bond market performance. Investing in an index is not possible. For Index Definitions see: TouchstoneInvestments.com/insights/investment-terms-and-index-definitions
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Investment return and principal value of an investment in a Fund will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. All investing involves risk.
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