The S&P 500 is giving investors a reassuring headline. Look beneath the surface, however, and the picture is considerably less comfortable.
Over the past month, the index has risen about 0.7 per cent. But that gain masks a striking divergence across the market. Only two sectors are in positive territory: technology, up 7.1 per cent, and communication services, up 3.3 per cent.
Almost everything else is falling. Financials are down about 7 per cent, materials 6.6 per cent, utilities 6.2 per cent and real estate 6.1 per cent.
The message from the market is increasingly clear: higher bond yields are putting pressure on equities, but the strength of artificial intelligence and the largest technology companies is concealing the damage.
That distinction matters.
Why higher yields matter
There are two straightforward ways higher government bond yields can hurt equities.
The first is relative value. If investors can earn more than 5 per cent from US government debt, equities need to offer a sufficiently attractive return to compensate for the additional risk.
The second is the cost of capital. Companies refinancing debt, households taking mortgages and businesses financing new investment all face more expensive money.
The effects, however, are uneven.
Banks are an obvious example. Higher interest rates can initially improve lending margins, but that benefit does not continue indefinitely. Funding costs rise, bond portfolios can lose value and expensive credit can suppress demand for mortgages and corporate loans.
If restrictive financial conditions persist, the market also begins to worry about loan losses.
The question therefore shifts from how much banks can earn from higher rates to whether higher rates are damaging credit growth and the quality of borrowers.
That helps explain why financials have become one of the weakest parts of the S&P 500.
The refinancing problem
The pressure is potentially greater for companies with weaker balance sheets.
Large companies were able to lock in historically cheap long-term financing when rates were near zero. Smaller businesses are often more dependent on shorter-dated debt, floating-rate borrowing and external capital.
When those debts mature, refinancing them at today’s rates can produce a substantial increase in interest expenses.
That feeds directly into profits.
The problem is particularly acute for businesses that were dependent on cheap capital to finance expansion. When money was abundant, investors were prepared to value companies on the basis of earnings that might arrive years into the future.
With government bonds yielding more than 5 per cent, the opportunity cost of waiting has changed.
Balance-sheet strength therefore matters more than it did during the era of ultra-cheap money.
Utilities caught in the middle
Utilities provide one of the clearest examples of the pressure created by higher yields.
Power companies and other infrastructure businesses require enormous amounts of capital to build and maintain their assets and consequently tend to carry substantial debt.
Higher borrowing costs increase the expense of new investment and refinancing.
But utilities face another problem: their attraction to investors has traditionally rested partly on stable dividend income.
A utility yielding 4 or 5 per cent looks considerably less compelling when investors can obtain a similar return from government bonds without taking the same degree of equity risk.
The sector is therefore being squeezed from both directions — by the cost of financing and by competition from safer income-producing assets.
Real estate faces a similar reckoning
Property companies and real estate investment trusts are even more directly exposed to financing conditions.
Large debt burdens mean that refinancing can materially increase interest costs. At the same time, higher bond yields can push property yields higher, putting pressure on valuations.
REITs also compete directly with bonds for income-seeking investors.
The important question is consequently not simply how much debt a property company carries, but when that debt matures and what rate it will have to pay when it is refinanced.
The S&P 500’s real estate sector has fallen about 6.1 per cent over the past month.
The economic damage comes next
Higher yields eventually extend beyond highly leveraged sectors.
Consumer discretionary companies, industrials and materials can be hit through a weaker economy.
More expensive mortgages can suppress housing activity. Higher car finance and credit-card costs can restrain household spending. Businesses facing a higher cost of capital may postpone factories, equipment purchases or other investment.
A company does not necessarily need a weak balance sheet to suffer from high rates. Its customers may have one.
That is when higher yields cease being primarily a valuation problem and become an earnings problem.
Why is technology still rising?
This is the market’s central contradiction.
Technology and other growth stocks have historically been vulnerable to rising yields because their valuations depend heavily on profits expected far into the future. Higher discount rates reduce the present value of those earnings.
Yet technology has risen more than 7 per cent over the past month.
Artificial intelligence has changed the calculation — at least for now.
Investors are betting that earnings growth generated by AI infrastructure, semiconductors, cloud computing and related investment can outweigh the valuation pressure created by higher rates.
The largest technology companies also have an advantage that many smaller or highly leveraged businesses lack: enormous cash flows and strong balance sheets.
They do not need to rely on increasingly expensive refinancing markets to fund their expansion.
The dividing line in today’s market is therefore becoming less about traditional growth versus value and more about companies that can finance their own growth versus those dependent on external capital.
The index is hiding the weakness
This is why the S&P 500 can provide a misleading impression of market health.
Its resilience is being supported by technology and communication-services companies with enormous index weights, while large parts of the market are already responding to higher yields.
The bond sell-off has not broken the S&P 500.
It has, however, weakened much of the market beneath it.
That creates a potentially uncomfortable dependency. As long as AI-related earnings remain strong, technology can continue to offset weakness elsewhere.
But the broader market is increasingly reliant on a relatively small group of companies delivering exceptional growth.
Three indicators therefore deserve close attention.
First, refinancing risk. Debt levels, interest expenses and upcoming maturities matter particularly for real estate, utilities and smaller companies.
Second, market breadth. If the index continues rising while an increasing number of sectors and individual stocks fall, the apparent strength of the market will rest on an ever narrower group of winners.
Third, AI earnings. Technology has so far provided the market’s shelter from higher yields. If AI-related earnings expectations weaken while bond yields remain elevated, that shelter could disappear quickly.
The lesson is that higher yields do not hurt every company in the same way.
For some, the problem is valuation. For utilities and real estate, it is financing costs and competition from bonds. For banks, it is weaker credit conditions. For cyclical companies, it is the threat of slower demand.
And, for now, AI remains the exception.
The bigger test for Wall Street will come if yields remain elevated for long enough that even exceptional AI earnings growth can no longer compensate investors for the rising cost of capital.
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