Why the Bond Market May Be the Stock Market's Biggest Risk

PodcastGoldman Sachs The MarketsTony PasquarielloSep 25

The guest identifies the bond market as the stock market's clearest near-term risk, as markets reprice rate expectations amid renewed attention to deficits, bond supply, and stronger growth. He also points to AI capital spending and fiscal deficits as forces that could offset Fed tightening, while expecting earnings growth and stock-market appreciation to slow but remain positive. He favors Japanese equities, citing shareholder reform and exposure to AI, advanced manufacturing, and defense.

Fixed Income Interest Rates Government Debt

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Key Takeaways

The guest describes a sharp shift in rate expectations—from anticipated cuts to a possible series of hikes, with the rate strip indicating about four hikes or more—but says roughly $1.3 trillion in projected AI capital spending next year and a $2 trillion annual deficit at full employment could provide a procyclical offset to Fed tightening.

The guest calls bonds the clearest current danger to stocks, citing debt and deficits, Treasury and AI-related bond supply, and stronger growth, with third-quarter GDP discussed at 3% or better. He says payrolls will guide bonds and, in turn, stocks, and notes that if investors seek equity hedges, short bond positions are worth considering given the historical pattern of stocks trading lower in early tightening cycles.

The guest expects S&P 500 earnings growth to decelerate from 25–30% to roughly 10–12%, while remaining positive, and guesses that the market’s rate of appreciation will slow but returns will stay positive overall. He notes the P/E has fallen from 23 to roughly 18–19, though that level remains around the 90th percentile of its historical range.

ECONOMY

Rate Repricing — The guest says markets have shifted from expecting a couple of rate cuts to pricing in a possible series of hikes. One hike had occurred, and the rate strip indicated about four more, perhaps more.

“Well, it's interesting. We started the year and the market, the interest rate market expected there'd be a couple of cuts this year…”—

AI CapEx Cycle — The guest describes AI hyperscaler capital spending as a major cyclical force, estimating about $150 billion in 2023 and projecting about $1.3 trillion next year. He sees that spending as a counterweight to concerns about Fed tightening.

“I think there's two dynamics in the context of countervailing forces to the worry about a fed tightening cycle. One is exactly that, which is the AI CapEx cycle…”—

MARKETS

Bond Market Risk — The guest calls the bond market the stock market's clearest present danger. He cites renewed focus on debt and deficits, Treasury bond supply, the AI CapEx buildout, and stronger-than-expected growth, with third-quarter GDP being discussed at 3% or better.

“If you were to ask me what's the number one kind of clear and present danger for the stock market, I'd say it is the bond market…”—

Bond Hedges — The guest says the S&P has generally traded lower in the early stages of Fed tightening cycles, and that tightening Fed liquidity has often helped end bull markets. If investors seek equity hedges, he says they should consider short positions in the bond market.

“If I look back at what has ended bull markets along that path, it usually does involve a tightening of Fed liquidity alongside other factors…”—

Earnings Deceleration — The guest expects S&P 500 earnings growth to slow from 25–30% to roughly 10–12%, while remaining positive. He says how the market responds to that slowdown is a key open question.

“Yeah. I think the biggest question is we've enjoyed this incredible earnings boom…”—

FORECASTS

Slower Returns — The guest guesses that the S&P 500's rate of appreciation will slow as earnings growth decelerates, though returns will remain positive overall. He notes that the P/E has fallen from 23 a year earlier to 18–19 alongside the earnings-driven rally.

“We're sitting here today. PE is '18, '19. Year ago, when we last spoke, it would have been '23. So very much driven by the earnings growth we're talking about…”—

Fed Hikes And Bond Yields

Pascarello describes the shift from expected rate cuts to hikes and says renewed pressure from rising bond yields, deficits, and bond supply is the stock market’s clearest near-term risk.

Bond Market Stock Risk

Pascarello says early tightening can weigh on equities but sees AI capital spending and large fiscal deficits as powerful cyclical forces that may offset some Fed restraint.

Earnings Growth And Valuations

The speakers expect earnings growth and equity returns to slow but remain positive, while noting that valuations are high yet less extreme than during the late-1990s tech boom.

Japanese Equities Opportunity

Pascarello favors Japanese equities, citing shareholder reforms and exposure to AI, advanced manufacturing, and defense, and says upcoming payrolls data could move bond and stock markets.