3 Emerging Long-Term Headwinds for the S&P 500

The S&P 500 (SNPINDEX: ^GSPC) returned 13% on an annualized basis over the past 10 years, a run so steady that double-digit gains came to feel routine. That era could be ending soon.

Broad-market index funds like the SPDR S&P 500 ETF Trust (NYSEMKT: SPY) and Vanguard S&P 500 ETF (NYSEMKT: VOO) are still going to be the cheapest way to own a diversified basket of the biggest American businesses. But three emerging headwinds in particular could make the next decade materially less generous to those who hold the market.

1. Cheap money isn't coming back

Since 2008, American corporations have been able to refinance their debt at ever-lower interest rates thanks to the Federal Reserve setting its policy rate near 0% to stimulate the economy. That borrowing subsidy is probably finished. Today, the 10-year Treasury yield trades near 4.5%, about double its norm from the 2010s. The Fed's June dot plot leans toward a hike rather than further cuts.

The shift is structural. The U.S. has record fiscal deficits and is adapting to newly deglobalized supply chains, pushing the neutral interest rate materially above its 2010s level. And so the amount businesses will need to pay toward their interest expenses on new borrowing will increase, leaving less leftover capital for investing in growth and likely less willingness to borrow at all.

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That hits index investors directly. Buybacks and dividends are funded by the cash left over after interest, so when interest expenses rise, payouts compete with capital expenditures for a smaller pool.

2. Heavier capex requirements could sap growth

The prior decade favored businesses that grew by adding computer code rather than new manufacturing equipment. AI is now likely to commoditize at least some of the labor inputs to that work, making it harder for those kinds of businesses to grow as quickly as before.

The AI creators themselves are also quite stretched. Hyperscaler capital expenditures (capex) may soon reach 75% of operating cash flows, with continued growth increasingly financed by debt.

What still faces real demand is the physical layer on which AI runs, such as computer chips, electrical substations, data centers, and grid equipment. But every dollar of that capex spending does not return to shareholders. Plus, because it's a physical product rather than a digital one, physical product providers usually don't get nearly as high a return on their invested capital or labor as the software majors of the current era do.

Broad exposure through low-cost S&P 500 ETFs will still work, but it's reasonable to expect per-share growth will take a big haircut, as each new dollar of revenue now requires a lot more investment to attain than before.

3. U.S. stocks are priced for perfection

The final emerging headwind is the bloated valuations of U.S. stocks. The Shiller price-to-earnings (P/E) ratio is 40, a level exceeded only once in 140 years of data: the December 1999 peak before the tech crash. U.S. large-cap stocks are now priced for a long stretch of near-flawless execution on their plans for earnings growth. That rarely turns out as planned for investors.

High valuations rarely trigger sell-offs, but they can hamper share price appreciation until earnings catch up, which can take quite some time. Goldman Sachs' strategy team forecasts a 3% annualized nominal return over the next 10 years, partly due to current valuations.

Finally, the U.S. market is going to have to grapple with the rest of the world's stocks being on the cheap side. The MSCI ACWI ex-USA index trades at a P/E of 14.6 against the S&P 500's 22.8. As foreign earnings recover, international stocks have stronger support than at any point in a decade.

A broad U.S. index fund is still the simplest, lowest-cost way to capture market growth, and it should remain a core tool for wealth building. But the expectations for its performance will need to (temporarily) change, as they might not top the past.

Alex Carchidi has positions in SPDR S&P 500 ETF Trust and Vanguard S&P 500 ETF. The Motley Fool has positions in and recommends Goldman Sachs Group and Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.