Impact of higher interest rates on US equities Report Interpretation

Overview

This US Weekly Kickstart examines how higher interest rates affect US equities through valuation, earnings and corporate balance sheets. Goldman Sachs acknowledges near-term pressure from sharp yield increases but argues that earnings resilience, strong balance sheets and already-priced policy tightening support a continuing bull market.

Core views

Goldman Sachs frames the report around a rapid rise in Treasury yields: the 30-year US Treasury yield reached 5.3%, its highest level in nearly 20 years, while the 10-year yield surged to nearly 5%, its highest level since October 2023. Following an above-consensus CPI print, its economists expect a 25 bp Fed rate increase at the next FOMC meeting. Its rates strategists attribute higher long-term yields to rising oil prices, a repricing of the expected Fed path, strong economic growth and AI investment. Higher rates have been a valuation headwind, but Goldman Sachs argues that the adjustment has not made equities materially less attractive relative to bonds. The S&P 500 forward P/E fell from 22x at the start of the year to 19x, amid higher rates as well as AI-related uncertainty and skepticism over the durability of recent earnings strength. Yet the index remained within 2% of its record high. The S&P 500 earnings yield was 5.2% versus a 2.6% real 10-year Treasury yield, leaving a 270 bp yield gap. The report says this proxy for the equity risk premium has been broadly stable over the last two years, as has the risk premium implied by its dividend discount model. The report distinguishes the initial market reaction to Fed tightening from the subsequent period. Across seven historical hiking cycles, the S&P 500 averaged a -2% return in the three months after the first hike, but averaged +9% over the following 12 months, with positive returns in every episode except 2022. In 1997, the index fell 10% alongside a 25 bp hiking cycle, then bottomed once markets stopped pricing further tightening and returned to new highs within three months. More than three additional 25 bp hikes are already priced by mid-2027, which Goldman Sachs says raises the threshold for a hawkish surprise. The key medium-term question is whether tightening damages earnings growth, which it views as the principal stock-market driver. Sector outcomes around prior first hikes were inconsistent: Energy and Technology had the strongest average three-month returns, Health Care the weakest, but no sector showed reliably consistent relative performance. Equities are more exposed to long-term and real interest rates than short-term or nominal rates because their value represents distant future cash flows. Goldman Sachs' dividend discount model estimates that roughly 75% of S&P 500 present value reflects cash flows more than 10 years ahead; its terminal-value calculation puts roughly 80% of current equity value in the residual value after forecasting earnings, dividends and net buybacks for 10 years. Accordingly, S&P 500 returns have shown their strongest rate correlation with long-dated bonds, and rising real yields are especially harmful because inflation can lift the nominal value of future cash flows. The pace of yield changes also matters. Stocks have generally generated positive returns alongside rising rates unless the rate rise exceeded two standard deviations. At present, a two-standard-deviation move in the 10-year yield is about 50 bp over a month or 30 bp over two weeks. Goldman Sachs says the rapidity of recent moves helps explain equity-market difficulty in absorbing them. Fundamental corporate-rate risk appears limited for the aggregate S&P 500. Borrowing costs have risen only modestly because most index debt is fixed-rate and long maturity, while interest expense remains small relative to strong profits. Aggregate S&P 500 interest coverage ranks in the 99th percentile of the past 20 years and the median stock ranks in the 68th percentile. Smaller companies are more exposed because they tend to have weaker balance sheets and larger floating-rate debt shares. Rate sensitivity varies materially within equities. Long-duration companies—those with high growth and low current profitability—are most vulnerable because much of their value rests on distant cash flows. Financials' earnings and share prices tend to benefit as rates rise. AI stocks, like the broad Information Technology sector, have shown a modest negative correlation with real yields. Home-construction-related equities are one of the clearest expressions of a long-term-rate view: they have traded closely with bond yields and underperformed the equal-weight S&P 500 by 16 percentage points since June. Goldman Sachs also explains how companies can offset higher discount rates. A lower risk premium or faster expected growth can preserve valuation; holding the equity risk premium constant, a 1 percentage point increase in cost of equity would require a 2 percentage point increase in expected long-term growth to fully offset the valuation impact. The report links this incentive to sustained AI investment: roughly half of S&P 500 companies discussed AI adoption to improve productivity during the latest earnings season, while others seek new revenue streams. It also identifies M&A and spin-offs as routes to alter growth trajectories. Announced US M&A totaled $1.4 trillion year to date and global volume rose 36% year on year; spin-offs have been muted, but higher rates may encourage companies to separate low-growth or non-core businesses. The report rebalances Goldman Sachs' sector-neutral Long Duration and Short Duration Russell 1000 baskets, excluding Financials and Real Estate. It estimates each stock's weighted-average cash-flow distribution to classify equity duration. The Long Duration basket has a median equity duration of 23.8 years, compared with 19.7 years for the Short Duration basket and 22.2 years for the Russell 1000 median. Its top-down S&P 500 forecasts call for EPS of $275 in 2025, $340 in 2026 and $385 in 2027, implying 12%, 24% and 13% respective growth rates. Goldman Sachs uses a 20x current P/E on next-12-month EPS, targets 8,000 for year-end 2026 and 8,300 over 12 months, representing stated returns to target of 5% and 9%.

Analysis framework

Goldman Sachs combines historical Fed-hiking-cycle comparisons with valuation analysis, rate-return correlations, corporate balance-sheet indicators and sector-level sensitivity analysis. It uses a multi-stage S&P 500 dividend discount model to connect discount rates, equity risk premiums, long-run growth and market value, then applies estimated cash-flow duration to construct sector-neutral long- and short-duration baskets.

Methodology notes

• Valuation methodsDDM (Dividend Discount Model)

  Multi-stage S&P 500 dividend discount model

  The model values the index from forecast earnings, dividends and net buybacks over 10 years plus terminal value. Goldman Sachs uses it to estimate the implied equity risk premium and show how higher discount rates affect valuations.

• Fixed Income and CreditThree-Factor Interest-Rate Decomposition

  Comparison of nominal and real Treasury yields, rate levels and rate volatility

  The report separates the effect of long-term, real and rapidly changing yields on equity valuations and returns, finding that real and long-dated rates are especially relevant.

• Quantitative, Factor, and Portfolio TheoryStyle factor analysis

  Equity-duration basket construction and rate-sensitivity regressions

  Goldman Sachs estimates the timing of stock cash flows, compares long- and short-duration groups, and examines return sensitivity to rates while maintaining sector neutrality.

Asset mapping & comparison

Structured mapping from thesis to named assets (strengths, weaknesses, peers, risks).

• Goldman Sachs Long Duration basket (GSTHLDUR)

  A sector-neutral Russell 1000 basket designed to represent stocks with distant expected cash flows and higher sensitivity to rising rates.

  Strengths

  Provides exposure to companies with longer estimated equity duration and higher prospective growth characteristics.

  Weaknesses

  Higher valuations are particularly vulnerable when real yields rise.

  Comparison

  Median equity duration is 23.8 years versus 19.7 years for GSTHSDUR and 22.2 years for the Russell 1000 median.

  Risks

  Sharp increases in long-term or real interest rates can pressure valuation.

• Goldman Sachs Short Duration basket (GSTHSDUR)

  A sector-neutral Russell 1000 basket representing stocks with nearer-term cash-flow profiles relative to the long-duration basket.

  Strengths

  Lower estimated equity duration may reduce relative sensitivity to rising yields.

  Comparison

  Median equity duration is 19.7 years versus 23.8 years for GSTHLDUR.

  Risks

  Basket trading depends on market conditions, including liquidity and borrow constraints.

Key data

• 30-year US Treasury yield5.3%Highest level in nearly 20 years.
• 10-year US Treasury yieldNearly 5%Highest level since October 2023.
• Expected Fed action25 bp hikeExpected at the next FOMC meeting after an above-consensus CPI print.
• S&P 500 forward P/E19xDown from 22x at the start of the year.
• Equity risk-premium proxy270 bpDifference between 5.2% S&P 500 earnings yield and 2.6% real 10-year Treasury yield.
• Historical first-hike S&P 500 return-2% over three months; +9% over 12 monthsAverage across seven hiking cycles; 12-month returns were positive except in 2022.
• Home-construction equity performance-16 percentage pointsUnderperformance versus the equal-weight S&P 500 since June.
• S&P 500 interest coverage99th percentile aggregate; 68th percentile median stockRelative to the past 20 years.
• Growth needed to offset higher cost of equity2 percentage pointsRequired long-term growth increase to offset a 1 percentage point cost-of-equity rise, assuming constant ERP.
• US announced M&A volume$1.4 trillion YTDGlobal announced M&A volume was up 36% year on year.
• S&P 500 EPS forecast$340 in 2026; $385 in 2027Goldman Sachs top-down forecast, implying 24% and 13% year-on-year growth.

Impact & implications

Goldman Sachs views higher yields as a valuation and near-term volatility challenge rather than an automatic end to the equity bull market. The report favors distinguishing between rate-sensitive long-duration and housing-related stocks, which are more exposed to rising yields, and financials, which typically benefit. It also highlights earnings growth, the pace of rate moves, real yields, balance-sheet resilience and corporate investment or restructuring activity as the mechanisms that determine whether higher rates become a broader equity problem.

Risks

• A sharp rise in bond yields—defined as more than two standard deviations—has historically been difficult for equities to absorb.
• The medium-term effect of Fed tightening depends on whether it weakens earnings growth.
• Smaller companies are more vulnerable because they generally have weaker balance sheets and greater floating-rate debt exposure.
• Long-duration stocks and housing-related equities are particularly vulnerable to higher long-term and real yields.

What to watch

• The next FOMC decision and whether policy expectations move beyond the more than three 25 bp hikes already priced by mid-2027.
• The level and speed of changes in long-term and real Treasury yields.
• S&P 500 earnings growth and evidence that higher borrowing costs are affecting corporate profits or solvency.
• AI-related capex and R&D, M&A activity and potential spin-offs as corporate responses to the need for faster growth.