When the S&P 500 (INDEXSP:.INX) surged over the summer, most analysts took this as evidence that the U.S. economy was recovering, but historically low borrowing costs helped ROE in eight out of ten sectors, say Goldman Sachs analysts Stuart Kaiser and Amanda Sneider, covering up some of the weakness from falling margins. Analyst sentiment is becoming incredibly bullish, but as interest rates begin to rise, which most people expect to happen within the next few quarters, there will be more pressure on companies’ margins.

Borrowing costs near historical low

“Borrow costs remain near historical lows and had the broadest positive contribution to ROE, helping eight of the ten S&P 500 (INDEXSP:.INX) sectors,” write Kaiser and Sneider, referring to the second quarter of this year, but “as interest rates rise, positive contributions to ROE from low borrowing costs could weaken.” Only financials and IT were hurt by the low borrowing costs, and leverage for S&P 500 excluding financials has been creeping upward for several successive quarters.

Borrowing costs sp500 leverage goes up 1013

Borrowing costs historic lows

Tapering to take over market again

Now that the debt ceiling fight has been averted, or at least kicked down the road a bit, markets will likely turn their attention back to tapering as the most important macro policy they need to face. While there’s no question that the U.S. economy is stronger than it has been in years, cutting off the constant source of government largesse and increasing interest rates could ratchet up the pressure on companies that have been riding on highly accommodating monetary policy.

“Over the past year, ROE for the Energy, Information Technology, and Telecom Services sectors have each fallen by more than 200 bp,” write Kaiser and Sneider. “Consumer Staples and Utilities were the only sectors to expand ROE in 2Q and also the only sectors to have positive contributions in at least four of the five DuPont components.”

That doesn’t mean the S&P 500 is overvalued, Kaiser and Sneider expect it to increase another 3 percent by the end of the year, but it might not be primed for the level of growth that some people are predicting. “S&P 500 (INDEXSP:.INX) currently trades around fair-value based on a variety of metrics. Future index returns will depend on growth in book value which is another way of saying that the valuation expansion phase of this market cycle is largely behind us.”