Wall Street is gripped by a high-rate anxiety as the 30-year Treasury yield has surged to 5.3%, a near two-decade high, with the 10-year yield approaching the 5% mark. Yet Goldman Sachs is presenting a starkly different reality: rising interest rates do not inevitably spell doom for equities, with corporate earnings being the true engine of the market.

According to the latest Goldman Sachs research report, the core thesis is that high rates act as a headwind for stocks but are not a force capable of ending the bull market. As long as earnings growth remains robust and corporate balance sheets stay healthy, the foundation for the current equity bull run remains solid enough to persist.

The report notes that although the S&P 500's forward P/E ratio has contracted from 22 times at the start of the year to 19 times, the relative valuation of stocks against bonds remains stable, with the equity risk premium holding at 3%. Investors are advised not to be shaken out by the initial pain of Fed tightening, which historically averages a 2% drawdown, as the average return for the S&P 500 over the subsequent 12 months has been a robust +9%. Goldman economists are projecting a 25-basis-point rate hike at the Fed's upcoming meeting.

Goldman points out that in the current environment, corporate balance sheets are exceptionally strong. Leveraging investments in AI, M&A, and spin-offs to boost earnings growth will be crucial for companies to defend against valuation compression and sustain the bull market. The bank argues that steering clear of homebuilders sensitive to long-end rates while embracing financials and high-growth potential names is the winning formula for today's market conditions.

Valuation Compression has Occurred, but Relative Stock-Bond Appeal is Largely Stable

The S&P 500's forward P/E has slid from 22 times at the start of the year to the current 19 times. This de-rating stems from a variety of factors, including uncertainties surrounding AI, doubts about the durability of recent strong earnings, and the direct pressure from rising yields.

However, Goldman's analysis reveals a critical fact: the attractiveness of stocks relative to bonds hasn't materially deteriorated. The yield gap between the S&P 500's earnings yield of 5.2% and the real 10-year Treasury yield of 2.6% currently stands at 270 basis points, a spread that has remained fairly steady over the past two years. The equity risk premium implied by Goldman's dividend discount model is around 3%, also having stayed relatively stable in recent years.

This indicates that rising rates have compressed absolute valuations but haven't systematically undermined the allocative value of equities versus bonds, which is a key pillar underpinning Goldman's bullish stance.

Historical Pattern: Pressure at First, But a +9% Average Return After 12 Months

The 10-year Treasury yield has spiked to near 5% this week, the highest level since October 2023, while the 30-year yield has climbed to 5.3%, edging closer to its peak of the last two decades. Goldman economists anticipate that, following a hotter-than-expected CPI print, the Fed will raise rates by another 25 basis points at next week's FOMC meeting.

Goldman's rates strategists attribute the upward move in long-end yields to a combination of rising oil prices, a repricing of the Fed's rate path, robust economic growth, and the AI investment boom.

The bank sees a significant buffer: rates markets have already priced in more than three 25-basis-point hikes by mid-2027, which somewhat raises the bar for further policy surprises and reduces the risk of a hawkish shock to the market.

Analyzing data from seven tightening cycles over the past decades, Goldman has identified a clear pattern: the S&P 500 averages a -2% return in the three months following the start of a hiking cycle, with only a 29% probability of a positive return during that window. Extending the horizon, the index averages a +9% return in the 12 months after the first hike, having achieved a positive return in every cycle except 2022.

The 1997 case serves as a valuable reference: the Fed hiked just 25 basis points, and the S&P 500 dropped 10% almost immediately. However, once the market stopped pricing in further tightening, stocks bottomed out and rallied to new highs within three months.

The medium-term impact of rate hikes on equities ultimately hinges on how monetary tightening affects earnings growth, the true core driver of stock prices. Goldman projects the S&P 500's earnings per share to reach $340 in 2026, a year-over-year increase of 24%, and to rise further to $385 in 2027, a 13% gain.

Stocks Show Heightened Sensitivity to Long Rates; Rate Volatility Adds Another Layer of Risk

From the fundamental logic of asset pricing, stocks represent a discount of long-term future cash flows. Goldman's DDM model shows that roughly 75% to 80% of the S&P 500's present value comes from cash flows beyond ten years out. Consequently, equity valuations are more sensitive to shifts in long-term yields, showing the strongest correlation with the 30-year Treasury yield.

Furthermore, Goldman stresses that not just the level of rates, but rate volatility itself, is a major source of risk for the stock market. Historical data indicates that equities typically struggle when rate movements exceed two standard deviations. Currently, a two-standard-deviation move in the 10-year Treasury yield equates to a rise of roughly 40 to 50 basis points in a single month. The recent rapid pace of the yield increase is a key reason for the pressure on stocks.

Healthy Balance Sheets Mean Low Fundamental Risk for Large Caps

Goldman's analysis shows that current S&P 500 constituents are generally well-equipped to withstand the fundamental impact of higher interest rates. The majority of S&P 500 companies hold debt with fixed interest rates and long maturities, meaning the effective increase in borrowing costs has been quite limited. The index's overall interest coverage ratio sits at the 99th percentile of the last two decades, with the median stock also at the 68th percentile, both historically high. Interest expenses remain small relative to robust corporate profits.

It is worth noting that small and mid-sized companies are in a more vulnerable position—they typically have weaker balance sheets, a higher proportion of floating-rate debt, and are more sensitive to rising rates.

Corporate Playbook: Growth is the Key to Sustaining Valuation as M&A and AI Investments Accelerate

Goldman's modeling provides a clear quantitative conclusion: for every one percentage point increase in the cost of equity, a company needs to raise its long-term growth expectations by two percentage points to fully offset the impact of higher rates on its valuation.

This pressure is driving a range of corporate responses. First, there is an increase in capital expenditure and R&D spending: in the latest earnings season, about half of S&P 500 companies discussed using AI technology to boost productivity on their calls, with some others planning to create new revenue streams via AI. The urgent need to enhance growth in a high-rate environment is one of the key supporting logics behind the current AI investment boom.

Second, M&A activity is accelerating. Announced U.S. M&A deals have reached $1.4 trillion year-to-date, while global M&A volume has grown 36% year-over-year. M&A serves as a crucial path for companies to rapidly improve their growth trajectory.

Third, spin-offs are on the horizon. Spin-off activity has been relatively subdued in recent years, but rate pressures could push more companies to divest low-growth or non-core businesses in an effort to streamline and seek growth.