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Valuations, Earnings, and the Pressure of Rising Rates

The stock market is a complex machine powered by investor sentiment, corporate earnings, fiscal health, and macroeconomic conditions. Right now, all four of these engines are being tested. From Moody’s downgrade of U.S. debt to renewed concerns over Treasury yields and the persistent uncertainty of global trade tensions, investors are facing a confluence of risk factors. Despite these headwinds, equity markets continue to find moments of relief, such as Monday’s rally following the postponement of new tariffs on Europe.

This article unpacks how company earnings and valuations interact, how rising interest rates challenge stock returns, and why the recent debt downgrade and spending outlook are sharpening market focus.

Company Earnings and Stock Valuations: The Core of Long-Term Value

At the most fundamental level, stock prices are derived from expectations about future earnings. A company’s valuation is typically expressed as a multiple of its earnings, such as the price-to-earnings (P/E) ratio. When earnings grow, and sentiment remains positive, valuations can expand—or at least be maintained.

However, when earnings slow or the future becomes more uncertain, the justification for high valuations weakens.

The "E" in P/E Is What Matters

Take today’s environment. Corporate earnings have remained resilient in some sectors, but are under pressure in others due to margin compression, rising input costs, and softening demand. According to FactSet, as of May 23, 96% of S&P 500 companies reported Q1 results with a blended growth rate of 12.9%, compared to estimates of 7.1% on March 31. Interestingly, it was feared that companies would stop giving earnings guidance during the quarter due to uncertainty. FactSet noted that only eight companies withdrew guidance this quarter, compared to 185 in Q1 2020, when companies were impacted by COVID lockdowns.

(Click on image to enlarge)

Source: FactSet

While most companies (259 in the S&P 500) continue to offer earnings guidance, FactSet suggests that this guidance is sustained by conservative estimates, cost mitigation, or minimal tariff impacts in some industries. While “uncertainty” has been the word thrown around regularly regarding tariffs and the heated trade war, companies in the S&P 500 are clearly showing the existing conditions aren’t even close to COVID.

Earnings reports have exceeded expectations. According to FactSet, 78% of companies surpassed earnings projections, while only 18% fell short. The Health Care, Information Technology, and Communication Services sectors were the primary contributors to these positive surprises.

As investors assess these earnings results, they also need to consider the quality and sustainability of those earnings. For instance, companies relying heavily on cost-cutting to maintain profitability or share-buyback programs to shrink shares might be masking slowing top-line growth. In such cases, markets often discount future growth and reduce valuations accordingly. FactSet reported last Friday that 63% of S&P 500 companies reported revenues above estimates, below the five-year average of 69% and the 10-year average of 64%. The magnitude of surprises above estimates is also below the 5- and 10-year averages. According to FactSet, the Health Care sector was the largest contributor to these surprises, while the Industrial sector was the largest detractor.

Growth-oriented companies, particularly in the tech sector, typically trade at higher P/E ratios because investors are pricing in future earnings potential. However, those future cash flows are more sensitive to changes in interest rates—more on that below.

Multiples Compress in Uncertainty

Valuation multiples—like P/E, price-to-sales, or other methods—tend to compress when uncertainty rises. Whether it’s political instability, fiscal deterioration, or interest rate volatility, investors are less willing to pay a premium for earnings when the macro picture darkens.

During March and April, markets experienced signs of multiple compression as investors grappled with rising trade and tariff uncertainty, prompting a broad repricing of risk across sectors. However, sentiment improved when President Trump paused his tariff threats for 90 days and made some progress with China, leading to a modest rebound in valuations. As of last Friday, FactSet reported a forward P/E ratio of 21.1 for the S&P 500—well above its 10-year average of 18.4—highlighting this recent expansion.

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Source: FactSet

Despite two negative developments this month—a weaker-than-expected Q1 GDP print and Moody’s downgrade of U.S. debt—the S&P 500 has largely shrugged off the news. But the market reaction shifted last week as interest rates spiked in response to poor government bond auctions from Japan and the U.S., coinciding with the House’s narrow passage of a major reconciliation bill expected to significantly increase deficits. This combination appears to have struck a nerve with investors—more on this below.

In this environment, the direction of interest rates and the outlook for government spending are becoming increasingly critical in determining how much investors are willing to pay for future earnings.

The Interest Rate Effect: Rising Yields and Their Competitive Threat

One of the most direct threats to high stock valuations is rising interest rates, especially those on long-dated Treasury securities like the 10-year yield.

In early 2024, yields had dipped below 4% on expectations of a soft landing and possible rate cuts. But those hopes have been tempered. The 10-year Treasury yield is now above 4.4%, which may seem modest historically but is significantly higher than the sub-2% yields prevalent for much of the past decade.

Why Rising Rates Matter

There are three primary reasons higher interest rates pressure equity markets:

1. Discount Rate Effect: Higher interest rates increase the discount rate applied to future cash flows, which reduces the present value of stocks—especially growth companies whose cash flows are farther in the future.
2. Opportunity Cost: As Treasury yields rise, fixed-income investments become more attractive alternatives. If investors can earn 4.4% "risk-free," they require a higher expected return from equities to justify the additional risk. This often leads to reallocation out of stocks and into bonds.
3. Economic Drag: Higher borrowing costs lead to slower economic activity as both consumers and businesses pull back. This weighs on revenue growth and earnings, feeding back into lower valuations.

Fixed Income Is Competitive Again

From 2010 to 2021, ultra-low interest rates left few alternatives to stocks. This phenomenon—nicknamed "TINA" for "There Is No Alternative"—drove money into equities and boosted valuations to historically high levels.

Today, that landscape has changed. With the 10-year yield now at 4.43%, investors are rethinking their allocation mix. For retirees and income-focused investors, high-quality bonds offer reliable income with lower risk, shifting the return calculus away from equities.

U.S. Fiscal Worries: Moody’s Downgrade and Budget Reconciliation Risks

Markets were rattled earlier last week when Moody’s downgraded U.S. sovereign debt from Aaa to Aa, citing long-term fiscal challenges and a deteriorating political environment. While the U.S. remains one of the most creditworthy nations, the symbolism of losing its last perfect rating cannot be ignored.

Adding fuel to the fire, the House of Representatives passed a controversial reconciliation bill by a razor-thin 215-214 margin. According to the Congressional Budget Office, this legislation would add $2.3 trillion to the deficit over the next decade and $3.1 trillion to the national debt immediately. With U.S. debt already at $36.9 trillion, the downgrade has reminded investors that there is no free lunch in fiscal policy.

Source: www.usdebtclock.org

The Interest Burden Problem

The rising cost of servicing federal debt is a critical long-term concern. As interest rates climb, so does the cost of maintaining the debt. In fact, interest on U.S. debt is now among the largest line items in the federal budget, competing with defense and Social Security.

If interest rates remain elevated, this will crowd out future government spending flexibility and could necessitate either tax increases or spending cuts—both of which would be economically restrictive. Markets are starting to price in that risk.

Geopolitical Uncertainty: Trade Tensions and Global Fragmentation

Just when markets were beginning to focus on domestic policy and interest rates, the specter of global trade tensions has returned.

President Trump recently threatened to increase tariffs on European imports, accusing the EU of "dragging its heels" in trade negotiations. Although the deadline for action has been postponed to July 9, the uncertainty has already begun to weigh on multinational corporations.

Why Trade Wars Matter

Trade restrictions increase costs for consumers, disrupt supply chains, and often lead to retaliatory tariffs. The impact can be seen directly in company earnings and forward guidance, especially for global manufacturers, technology firms, and exporters.

Interestingly, markets rallied Monday on the delay of the tariff escalation, reflecting investor relief that the immediate threat has been pushed out. But make no mistake: if tariffs are implemented later this summer, the earnings outlook for many companies could deteriorate, especially those with international exposure.

In Gold We Trust?

Gold has been asserting its role as a safe-haven asset amid growing economic and geopolitical uncertainty. While equities have posted mixed reactions to news on trade negotiations, rising debt levels, and shifting inflation expectations, gold has steadily attracted capital for several key reasons.

First, trade wars and tariff threats—especially between the U.S., China, and now potentially Europe—have increased global uncertainty. Tariffs can raise production costs, disrupt supply chains, and weigh on corporate earnings. For investors concerned about the ripple effects of these tensions, gold provides a refuge. Unlike equities, which can be directly impacted by trade policy, gold operates outside traditional financial systems and isn't tied to any one nation’s economic performance. As a result, demand for gold often increases during periods of escalating global friction.

Second, gold’s appeal as an inflation hedge is gaining attention. With the U.S. passing large spending bills and running persistent deficits, many investors are worried that inflation could reaccelerate or remain structurally elevated. While inflation has come off its peaks, the underlying forces—tight labor markets, energy instability, and rising service costs—haven’t fully resolved. Gold tends to perform well in inflationary environments because it retains intrinsic value as fiat currencies weaken in purchasing power. Unlike bonds or cash, gold isn’t eroded by rising consumer prices.

Finally, gold is benefiting from concerns over long-term U.S. fiscal responsibility. Moody’s recent downgrade of U.S. sovereign credit and the Congressional Budget Office’s projection that recent legislation could add over $3 trillion to the national debt have underscored growing skepticism about America's financial trajectory. With U.S. debt now approaching $37 trillion and interest costs ballooning, some investors are seeking shelter in hard assets. Gold’s limited supply, global liquidity, and historic role as a store of value make it a natural alternative for those losing confidence in the sustainability of government spending and monetary policy.

Source: Stockcharts.com, Ryan Puplava, CMT® CTS™ CES™

In this context, gold is not just an inflation hedge or geopolitical play—it’s a vote of no confidence in a global system that increasingly relies on stimulus, debt accumulation, and financial engineering. If uncertainty around trade, interest rates, and fiscal policy persists, gold is likely to remain in favor as a hedge.

The Path Forward: What Investors Should Watch

Given the layered complexity of today’s market environment, what should investors be watching?

1. Earnings Quality, Not Just Quantity

With cost inflation, labor pressures, and demand shifts, it’s crucial to evaluate whether companies are growing through pricing power, efficiency, or financial engineering. Investors should focus on sustainable free cash flow and revenue diversification. I favor companies in finance, software, healthcare, and infrastructure, which have less exposure to tariff and trade issues.

2. Valuation Discipline

This is not 2021 or 2024. Blindly chasing growth stocks with triple-digit P/E ratios is no longer prudent. With the S&P 500 P/E ratio above historical averages, investors should be mindful of sectors or companies with stretched valuations and reassess their risk exposure accordingly.

3. Interest Rate Trends – Lots of Moving Parts

Yields fell sharply in April as recession fears intensified following renewed tariff threats. Those concerns eased somewhat in the short term after President Trump announced a 90-day pause and resumed negotiations with China. However, last week’s threat to impose tariffs on Europe—followed by yet another one-month delay on Monday—demonstrates that the trade war is far from over. This back-and-forth continues to inject volatility into the markets. More tariff escalations would likely compress equity valuations, while meaningful trade agreements could support a rebound in asset prices.

One key metric to monitor is the 10-year Treasury yield. If it stabilizes around 4.4% or begins to climb higher due to rising debt concerns, it could pressure high-valuation sectors like technology and consumer discretionary. Recently, Senator Ron Johnson (R-WI) told CNN that enough Republican senators may withhold support for the House reconciliation bill unless it includes deeper spending cuts. Should meaningful cuts be added to the legislation, we could see a relief rally in bonds, easing some upward pressure on yields.

In the short run, inflation remains a critical risk. If companies respond to tariffs by passing higher input costs on to consumers instead of absorbing them and reducing margins, we could see a price shock that weakens consumer demand. Such a retrenchment would threaten overall growth. From the bond market's perspective, rising consumer prices erode purchasing power, forcing investors to demand higher yields in compensation. This makes inflation data a critical input for fixed income investors navigating the current environment.

Over the longer term, a prolonged trade war could drag the U.S. into a broader economic downturn. In that scenario, monetary policy would likely pivot, with the Fed cutting interest rates to support growth. Long-duration bond investors could then step in, anticipating lower future rates, which would drive bond prices higher and yields lower—reversing the recent trend. Labor market data will also be important to watch, especially unemployment claims, as companies under pressure may begin cutting costs through layoffs or reduced hiring, which could foretell a broader economic slowdown.

4. Policy and Political Signals

With a large reconciliation bill in the works, U.S. fiscal policy will remain in the spotlight. A shift toward more discipline—or conversely, another wave of large spending—could impact yields, inflation expectations, and credit ratings.

5. Geopolitical Catalysts

Don’t ignore July 9. The 90-day tariff pause is set to expire that day and August 14 for U.S.-China trade. The clock is ticking. If trade tensions reignite, as we saw last Friday, we could see another round of volatility that challenges corporate forecasts and investor confidence.

Final Thoughts

Stock valuations do not exist in a vacuum. They are constantly being recalibrated based on earnings, macroeconomic variables, fiscal realities, and geopolitical risk. In the current environment, investors are navigating all these simultaneously.

Earnings remain a central pillar of market strength, but as interest rates rise and global uncertainties mount, the margin for error narrows. Moody’s downgrade of U.S. debt is more about its timing than the adjustment itself, given Republican plans to extend Trump tax cuts and introduce additional ones. The reconciliation bill’s $2.3 trillion deficit impact is not just a policy debate—it has real consequences for interest rates, inflation expectations, and capital flows.

For long-term investors, this is not a time to panic—but it is a time for prudence. Focusing on quality, managing risk, and maintaining diversification are more important than ever as the market recalibrates to a world where the cost of capital is no longer free.

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