‘That cushion has come down’: Dalio warns rising bond yields threaten stocks

Billionaire investor Ray Dalio warned Thursday that stocks face mounting pressure from rising bond yields and the prospect of weaker corporate cash flows, even as earnings continue to grow, CNBC reports.

Stocks have so far weathered the global bond selloff because earnings growth has kept expected equity returns attractive relative to bonds, Bridgewater Associates founder Dalio told CNBC. But that advantage will narrow, he says, potentially leaving equities more vulnerable as financial conditions tighten.

“We’re in the part of the cycle where interest rates can rise without sending the equity market down because there’s enough earnings growth and there’s enough expected return. But when that cushion comes down, then you’re coming later into that cycle. So that’s where we are,” Dalio said.

Equities entered the current cycle offering significantly higher expected returns than bonds, which helped sustain demand for stocks even as borrowing costs rose. But as stock prices climb and bond yields increase, that relative advantage is diminishing, leaving less room for equities to absorb higher rates, the billionaire added.

“Because of that change in pricing, that cushion has come down, and so now you’re starting to see credit spreads start to widen,” he argues.

Dalio cautioned that investors may be overlooking the risk of deteriorating corporate cash generation, even as earnings continue to improve. “I think you have to pay attention to free cash flows... Not just earnings. Because if you’re earning and then you’re investing and you’re not getting money out of that, you have a liquidity issue that’s evolving. While earnings should continue to be improving, I would expect the free cash flows, I think, will be deteriorating,” he told CNBC.

At the same time, Dalio stopped short of predicting an earnings decline or an imminent stock-market correction. He said financial conditions have not yet tightened enough to significantly curb credit and spending.

Still, the billionaire expects the global bond selloff to continue as governments and companies compete for capital. “We are in a bond bear market, that’s I think, pretty clear, and I think that there’s more to go would be my guess,” he said.

Higher borrowing costs will eventually force a reduction in credit and spending, weighing on economic activity and potentially spilling over into equity markets, Dalio added. For now, the tightening process is only beginning, with earnings growth still providing support for stocks even as credit conditions start to weaken, he said.

U.S. Treasury yields are hovering near multi-decade highs. The yield on the benchmark 10-year U.S. Treasury climbed more than 5 basis points on Thursday to 5.354%, remaining at levels last seen in 2002, CNBC reports. The 30-year Treasury yield was also trading near a 24-year high at 5.733% after an increase of more than 4 basis points.

On Wednesday, Dalio warned that AI was a “classic bubble” nearing the point of bursting. Rising interest rates and the need to convert wealth into cash are bringing that moment closer, the billionaire said, as reported by Bloomberg. He identified other factors that could trigger the collapse of the AI market like wealth taxes and investors’ efforts to convert unrealized gains into cash.

Also Wednesday, BofA analyst Savita Subramanian said equities face genuine competition from bonds for the first time in decades. In her view, "very bullish" investor sentiment leaves stocks more exposed to disappointment than poised for further gains.