"The cushion has shrunk": Dalio warned of stock market vulnerability due to bond yields

Billionaire and investor Ray Dalio warned on October 8 that stocks are facing mounting pressure due to rising bond yields and the prospect of deteriorating corporate cash flows, despite continued growth in corporate earnings, according to CNBC.

So far, stocks have successfully weathered the global bond sell-off, as earnings growth has supported the attractiveness of expected stock returns relative to bonds, Bridgewater Associates founder Ray Dalio told CNBC. However, this advantage will diminish, he noted, potentially making stocks more vulnerable as financial conditions tighten.

“We are at a stage in the cycle where interest rates can rise without causing the stock market to decline, because there is sufficient earnings growth and sufficient expected returns. But when that safety cushion runs out, you move into a later stage of the cycle. That’s where we are right now,” Dalio said.

At the start of the current cycle, stocks offered significantly higher expected returns compared to bonds, which helped sustain demand for equities even as borrowing costs rose. However, as stock prices rise and bond yields increase, this relative advantage is diminishing, leaving less and less room for risky assets to absorb higher interest rates, the billionaire added.

"Due to changes in pricing, this buffer has shrunk, so now you're starting to see credit spreads widen," he noted.

Dalio cautioned that investors may be overlooking the risk of a decline in companies’ cash flow generation, even though earnings metrics continue to improve. “I think you should pay attention to free cash flow… and not just earnings. Because if you’re making money, then investing it, and not getting that money back, you have a liquidity problem. While earnings should continue to grow, I believe free cash flow will deteriorate,” he said.

At the same time, Dalio refrained from predicting a decline in profits or an inevitable correction in the stock market. He noted that financial conditions are not yet tight enough to significantly restrict lending and spending.

But the billionaire said he expects the sell-off in the global bond market to continue as governments and companies vie for capital. “We are in a bond bear market: this is, in my view, absolutely obvious, and I think the decline will continue,” he noted.

Higher borrowing costs will ultimately force a reduction in lending and spending, which will put pressure on economic activity and potentially spill over into the stock markets, Dalio added. According to him, the tightening cycle is just beginning, and earnings growth continues to support stocks, even as credit conditions begin to deteriorate.

Yields on U.S. Treasury bonds are holding near multi-year highs. The yield on benchmark 10-year U.S. Treasury bonds rose by more than 5 basis points on October 8, reaching 5.354% and settling at levels not seen since 2002, according to CNBC.

Yields on 30-year Treasury bonds also traded near 24-year highs at 5.733% after rising by more than 4 basis points.

On October 7, Dalio warned that, in his view, artificial intelligence represents a “classic bubble” and is now approaching the point of bursting. According to the billionaire, rising interest rates and the need to convert accumulated capital into cash are contributing to this looming threat, Bloomberg reports. He also cited other factors that could trigger a collapse of the AI market, including taxes on large capital holdings and investors’ attempts to lock in unrealized gains in cash.

Also on October 7, Bank of America analyst Savita Subramanian stated that stocks are facing real competition from bonds for the first time in decades. In her view, overoptimistic investor sentiment makes stocks more vulnerable to disappointment than it does promise them growth.

This article was AI-translated and verified by a human editor