Ray Dalio warns the stock market's cushion against rising bond yields is shrinking

Billionaire investor Ray Dalio warned on Thursday that stocks face mounting pressure from rising bond yields and the prospect of weaker corporate cash flows, even as earnings continue to grow.

The Bridgewater Associates founder told CNBC equities have so far weathered the global bond sell-off because earnings growth has kept expected stock returns attractive, relative to bonds. But that advantage will narrow, he said, potentially leaving equities more vulnerable as financial conditions tighten.

"We're in the part of the cycle where interest rates can rise without sending the equity market down because there's enough earnings growth and there's enough expected return," Dalio told CNBC's Sri Jegarajah at the Milken Institute Asia Summit in Singapore on Thursday.

"But when that cushion comes down, then you're coming later into that cycle. So that's where we are."

His warning comes as U.S. Treasury yields hover near multi-decade highs. Investors are grappling with large government deficits, persistent inflation and rising borrowing tied to artificial intelligence investment.

Dalio said equities entered the current cycle offering significantly higher expected returns than bonds, helping sustain demand for stocks even as borrowing costs rose.

But as stock prices climb and bond yields increase, that relative advantage is diminishing, leaving less room for equities to absorb higher rates.

"Because of that change in pricing, that cushion has come down, and so now you're starting to see credit spreads start to widen," he said.

Dalio also cautioned that investors may be overlooking the risk of deteriorating corporate cash generation, even as headline earnings continue to improve.

Asked whether companies could sustain strong profit growth in the third quarter, Dalio said investors should focus on free cash flow rather than earnings alone.

"I think you have to pay attention to free cash flows. ... Not just earnings. Because if you're earning and then you're investing and you're not getting money out of that, you have a liquidity issue that's evolving," he said.

"While earnings should continue to be improving, I would expect the free cash flows, I think, will be deteriorating."

Dalio stopped short of predicting an earnings decline or an imminent stock market correction. He said financial conditions have not yet tightened enough to significantly curb credit and spending.

Dalio also said he expected the global bond sell-off to continue as governments and companies compete for capital, as mounting debt issuance puts pressure on investor demand.

Governments are borrowing heavily to finance fiscal deficits, while companies are raising funds to invest in emerging technologies, creating an imbalance that could keep upward pressure on interest rates.

"We are in a bond bear market, that's I think, pretty clear, and I think that there's more to go would be my guess," he said.

Higher borrowing costs will eventually force a reduction in credit and spending, weighing on economic activity and potentially spilling over into equity markets, Dalio said.

For now, Dalio said the tightening process is only beginning, with earnings growth still providing support for stocks even as credit conditions start to weaken.