Amid stretched valuations, look to non-U.S. equities and local bonds

The economy is operating at two speeds, with AI‑related areas absolutely booming while other segments—manufacturing in particular—are lagging. Fiscal expansion is just starting to hit its stride, which will boost AI (artificial intelligence) spending even further, and the Trump administration’s prioritization of deregulation should propel the overall economy toward healthy growth in 2026. But looking across asset classes, valuations almost everywhere appear extended, clouding the outlook. Where does our Asset Allocation Committee see tactical asset allocation opportunities in this landscape?

Inflation risk leads to underweight bonds

While expansionary fiscal policy, including tax incentives for capital expenditure, will support growth, many of the U.S. administration’s policies are also inflationary. This includes restricting immigration and imposing tariffs. Whether inflation stays near the 3% level—above the Federal Reserve’s target rate—or accelerates in 2026, it will erode the value of bonds. This leads us to favor stocks over bonds.

International and small-cap equities are best positioned

Comparing the outlooks for international and U.S. equities, we see more room for non‑U.S. stocks to advance as they catch up to the U.S. in AI‑related sectors. Also, the Chinese government appears dedicated to supporting innovation in AI and other technologies as a way to offset the economic drag and rising unemployment from the country’s severe real estate downturn.

Although the U.S. fiscal stimulus is sizable, the pivot toward expansionary policies outside the U.S.—particularly in countries like Germany—has been more abrupt, so we expect it to provide a larger relative impact. The European Central Bank, the Bank of England, and many emerging market central banks have also eased monetary policy much more than the Fed, providing further support for international stocks.

While we are neutral on growth versus value stocks in the U.S., in international equities we prefer value companies. The global cyclical backdrop is improving, and sectors such as financials—heavily represented in value indexes—should benefit from steeper yield curves and improving loan demand. Valuations for non‑U.S. value stocks also remain relatively attractive.

We anticipate some broadening of equity market performance away from the U.S. mega‑cap technology stocks and expect small-caps to be the biggest beneficiaries of that shift. Because of the enormous market capitalization of the “Magnificent Seven,” even a modest move into small-caps would provide a relatively large boost to smaller stocks. Small-caps also tend to gain the most from lower short‑term interest rates, which contributes to our decision to modestly overweight small-cap equities.

Leaning toward high yield bonds and non‑U.S. currency exposure

In the fixed income allocation, we view high yield bonds as an attractive, lower‑risk way—relative to equities—to benefit from a strong economy. Overall credit quality in the asset class is the highest in years, and we don’t anticipate any deterioration in its fundamentals in 2026. Non-investment-grade bonds also have some duration,¹ which would help cushion the asset class if the economy falls into recession. 

We favor taking some currency risk in fixed income through locally denominated international developed market and emerging market bonds. The U.S. dollar’s decline through most of 2025 is likely to extend into 2026 as the Fed cuts short‑term rates even as other central banks are much further along in their easing cycles. Also, U.S. inflation remains sticky, with the potential to increase even more. We see an overweight to unhedged local non‑U.S. bonds as an attractive way to benefit from that trend.

Key takeaway
We favor stocks over bonds as we expect the two-speed economy to avoid recession, and non-U.S. currency exposure as a way to benefit from likely U.S. dollar weakness.

 

 

Appendix

Financial Terms: Investors in the U.S. and Canada, for a glossary of financial terms, please go to troweprice.com/glossary.

Investment Risks:

Active investing may have higher costs than passive investing and may underperform the broad market or passive peers with similar objectives. Each person’s investing situation and circumstances differ. Investors should take all considerations into account before investing.

International investments can be riskier than U.S. investments due to the adverse effects of currency exchange rates, differences in market structure and liquidity, as well as specific country, regional, and economic developments. The risks of international investing are heightened for investments in emerging market and frontier market countries. Emerging and frontier market countries tend to have economic structures that are less diverse and mature, and political systems that are less stable, than those of developed market countries.

Commodities are subject to increased risks such as higher price volatility, geopolitical and other risks. Commodity prices can be subject to extreme volatility and significant price swings.

Inflation-Linked Bonds (Treasury Inflation Protected Securities in the U.S.): In periods of no or low inflation, other types of bonds, such as US Treasury Bonds, may perform better than Treasury Inflation Protected Securities (TIPS).

Investing in technology stocks entails specific risks, including the potential for wide variations in performance and usually wide price swings, up and down. Technology companies can be affected by, among other things, intense competition, government regulation, earnings disappointments, dependency on patent protection and rapid obsolescence of products and services due to technological innovations or changing consumer preferences.

Because of the cyclical nature of natural resource companies, their stock prices and rates of earnings growth may follow an irregular path.

Financial services companies may be hurt when interest rates rise sharply and may be vulnerable to rapidly rising inflation. Health sciences firms are often dependent on government funding and regulation and are vulnerable to product liability lawsuits and competition from low-cost generic product.

The value approach to investing carries the risk that the market will not recognize a security’s intrinsic value for a long time or that a stock judged to be undervalued may actually be appropriately priced. Growth stocks are subject to the volatility inherent in common stock investing, and their share price may fluctuate more than that of a income-oriented stocks.

Small‑cap stocks have generally been more volatile in price than the large‑cap stocks. Investing in private companies involves greater risk than investing in stocks of established publicly traded companies. Risks include potential loss of capital, illiquidity, less available information and difficulty in valuating private companies. They are not suitable, nor available, for all investors.

All investments involve risk, including possible loss of principal. Diversification cannot assure a profit or protect against loss in a declining market. Index performance is for illustrative purposes only and is not indicative of any specific investment. Investors cannot invest directly in an index.

Fixed‑income securities are subject to credit risk, liquidity risk, call risk, and interest‑rate risk. As interest rates rise, bond prices generally fall. Investments in high‑yield bonds involve greater risk of price volatility, illiquidity, and default than higher‑rated debt securities. Investments in bank loans may at times become difficult to value and highly illiquid; they are subject to credit risk such as nonpayment of principal or interest, and risks of bankruptcy and insolvency. Some or all alternative investments such as private credit, may not be suitable for certain investors. Alternative investments are typically speculative and involve a substantial degree of risk. In addition, the fees and expenses charged may be higher than the fees and expenses of other investment alternatives, which will reduce profits. As interest rates rise, bond prices generally fall. Investments in high yield bonds involve greater risk of price volatility, illiquidity, and default than higher rated debt securities.

T. Rowe Price cautions that economic estimates and forward‑looking statements are subject to numerous assumptions, risks, and uncertainties, which change over time. Actual outcomes could differ materially from those anticipated in estimates and forward‑looking statements, and future results could differ materially from any historical performance. The information presented herein is shown for illustrative, informational purposes only. Any historical data used as a basis for this analysis are based on information gathered by T. Rowe Price and from third‑party sources and have not been independently verified. Forward‑looking statements speak only as of the date they are made, and T. Rowe Price assumes no duty to and does not undertake to update forward‑looking statements.