Three market segments we like in a policy-driven environment

The T. Rowe Price Asset Allocation Committee (AAC) remains constructive on the U.S. economy heading into the midterm elections. Economic growth has held up, and inflation readings have come in better than expected. At the January AAC meeting, several committee members emphasized that policy support is likely to remain strong. One said, “The administration is going to pull any lever it can.”

That view seems to be widely shared across markets. Stock and bond valuations are near historic highs, and investor positioning reflects optimism. “If I look three years out, I don’t want to pay these valuations,” a committee member said. “But for the next six months? They could stay the same or go higher.” As a committee, we see near-term upside but limited margin for error.

This tension argues for balance. We chose to stay neutral at the stock/bond level and express our views via underlying segments with compelling relative value. That approach keeps us invested while aiming to improve the diversification of our active risk.

Value-oriented opportunities

While the AAC continues to express tactical allocation views through a variety of exposures, we see improving risk/reward profiles in three particular areas: U.S. small-caps, international small-caps (developed market ex-U.S.), and emerging market (EM) debt.

1. U.S. small-caps

Domestic small-caps remain an overweight position in the AAC’s portfolio, offering attractive entry points and exposure to cyclical sectors of the U.S. economy. These sectors are gaining momentum.

Market performance has recently broadened amid an improved earnings outlook for smaller companies. We expect this cyclical broadening to continue, especially with policy actions designed to run the economy hot. It’s not far-fetched to see nominal U.S. GDP growth of 7%–8%,¹ a rate that hasn’t been reached in decades, with the exception of the early pandemic rebound.

Within small-caps, we maintain balanced exposures.

Small-cap value is well positioned for this environment, standing to benefit from domestic growth, easing financial conditions, and lower short-term borrowing rates. Smaller banks could gain from deregulation and loan growth. Small-cap growth, on the other hand, provides leverage to key technology themes, including many artificial intelligence (AI) beneficiaries.

This combined structure avoids overcommitting to a single narrative and improves diversification within the allocation.

2. International small-caps

We also continue to overweight international small-caps, which offer attractive valuations, both on an absolute historical basis and relative to other international segments.

However, valuation alone isn’t a catalyst for outperformance.

“International small-caps need a pickup in construction activity, which has been dormant,” a committee member stated. If construction and capital spending recover even modestly, small-caps should benefit disproportionately.

We see signs that this could be underway. Europe and Japan, in particular, show improving growth prospects on the back of fiscal stimulus and reinvestment in infrastructure and strategic industries.

Diversification benefits also factor into our tactical bias for ex-U.S. small-caps. Whereas our international value overweight enables us to potentially benefit from structural drivers (such as the effects of positive interest rates on European banks), international small-caps provide better leverage to industrial and consumer-related tailwinds.

3. Emerging market debt

We also reaffirmed an overweight to EM bonds during our January meeting. This was a relative value decision, not an absolute valuation call.

Spreads in EM debt are tight. We recognize that. However, technical conditions are supportive of the asset class.

“There are a lot of flows coming into EM debt,” a committee member emphasized. After several years of outflows, demand has turned positive. And dollar weakness appears likely to persist, providing a continued tailwind.

Fundamentals are also constructive for EM bonds, particularly in Latin America. Policy credibility has improved. Inflation has rolled over. Several countries are positioned for interest rate cuts. Moreover, valuations in the region remain more attractive versus the broad index.

Key risks

Inflation remains the main uncertainty. Views differ on the committee. Some members see upside risk. Others see inflation as contained. Still, we maintain overweight positions in real assets and inflation-linked debt given the possibility of fiscal and commodity-related pressures.

Rate volatility has been muted, but that could change. Asset prices also assume a smooth policy path. “We live in a volatile world geopolitically and economically,” a committee member said. “Valuations assume nothing bad will happen.” That reinforces our preference for balance and relative value over a directional risk-on stance.

Neutral but opportunistic

The AAC’s portfolio remains invested, and we believe our risk budget is more balanced. Our positioning reflects both opportunity and discipline as we approach the midterms.