Key points: Ray Dalio stated that earnings growth once helped the stock market absorb the impact of rising bond yields, but this favorable condition is steadily weakening.

Dalio expects that even if corporate earnings continue to improve, free cash flow conditions will still deteriorate.

He said the bond selloff will continue as governments and corporations compete for capital.

Billionaire investor Ray Dalio, founder of Bridgewater Associates, issued a warning on Thursday: although corporate earnings are still growing, the stock market is facing increasing pressure from rising bond yields and potentially weakening corporate cash flows.

The Bridgewater founder said that so far, the stock market has withstood the global bond selloff because earnings growth has kept the expected return on equities attractive relative to bonds.

But he said this advantage will narrow, and as financial conditions tighten, the stock market may become more vulnerable as a result.

Speaking on Thursday at the Milken Institute Asia Summit in Singapore in an interview with reporter Sri Jegarajah, Dalio said: "At this stage of the economic cycle, rising interest rates will not directly crush the stock market, because earnings growth is sufficient and expected equity returns are solid."

"But once this cushion gets thinner, it means the economic cycle is in its later stage, and that is where we are now."

His warning came as U.S. Treasury yields hover near multi-decade highs.

Investors are facing multiple challenges: large government fiscal deficits, stubbornly high inflation, and borrowing demand driven up by artificial intelligence-related investment.

Dalio said that at the beginning of this economic cycle, the expected return on stocks was far higher than that on bonds.

Even as borrowing costs rose, this advantage supported market demand for equities.

But as stock prices climb and bond yields rise, this relative advantage of equities is fading, and the stock market's room to withstand higher rates is getting smaller and smaller.

He said: "It is precisely because of this change in valuation levels that the cushion has been compressed. Now we can already see credit spreads starting to widen."

Earnings versus cash flow

Dalio also cautioned that even if reported earnings figures continue to improve, investors may be overlooking the risk of deteriorating corporate cash-generating capacity.

When asked whether companies can sustain strong profit growth in the third quarter, Dalio suggested that investors should not only look at earnings but also pay attention to free cash flow.

"Everyone must watch free cash flow... you can't just stare at earnings. If a company reports accounting profits but keeps investing without getting actual cash back, a liquidity crisis will gradually breed," he said.

"Although corporate earnings are expected to continue improving, I expect free cash flow to deteriorate."

Dalio did not assert that corporate earnings would decline, nor did he predict an immediate stock market pullback.

He said the current degree of financial tightening is not yet enough to significantly curb credit supply and consumer spending.

The bond selloff is not over yet

Dalio also noted that governments and companies are competing for capital, and expanding debt issuance is testing investors' capacity to absorb it, so the global bond selloff will continue.

Governments are borrowing heavily to fill fiscal deficits, while companies are raising funds to position themselves in emerging technologies, and this supply-demand imbalance may continue to push interest rates higher.

He said: "I think it is very clear that we are in a bond bear market, and in my judgment, the decline will continue further."

Dalio said high borrowing costs will eventually force credit to contract and consumer and investment spending to fall, dragging down economic activity, and the risk could spread to the stock market.

However, Dalio also noted that the tightening process has only just begun.

Although credit conditions are starting to weaken, earnings growth is still providing support for the stock market.