Goldman says it's eyeing the risk of a deeper market correction that will leave investors few places to hide

• Goldman Sachs flagged the risk of a deeper stock decline, with bonds offering little protection.
• Strategists outlined a bear-case scenario in which the S&P 500 could drop another 8%.
• Bonds haven't been acting like safe havens, largely due to higher inflation expectations.

Goldman Sachs sees the potential for more pain in the stock market and warns that investors may have fewer options as they seek safe havens.

In a note to clients on Thursday, strategists at the Wall Street firm said they were eyeing risks of a coming stock correction, which is officially defined as the market dropping 10% or more.

The S&P 500 is already down 5% from its late January peak. Should the S&P 500 enter correctional territory, that implies at least another 5 percentage point drawdown in the index. The bad news is that bonds are unlikely to provide protection in the event of a deeper decline, the bank said.

The bank outlined various "more adverse scenarios" for stocks based on its cross-asset analysis and its Risk Appetite Indicator, a gauge of investor sentiment. In one scenario, strategists saw the risk of equities dropping another 7% to 8% from their current levels.

"We continue to see risks of further equity correction and think the buffer from bonds will remain limited near term," they wrote.

The strategists pointed to several headwinds in the equity market that were unlikely to abate anytime soon, such as AI disruption, geopolitical conflict, and — most recently — fears of hotter inflation. Investors have been panicking over the surge in oil prices, which could stoke inflation while cutting into economic growth — a negative for equities.

But the prospect of higher inflation has also been a negative for bonds — and investors are already seeing signs that bonds aren't acting like the safe havens they've historically been. The 10-year US Treasury yield, a reflection of long-term interest rate expectations in the economy that is responsive to inflation expectations, ticked higher to 4.31% on Friday, up 35 basis points since the Iran war began.

Goldman strategists pointed to higher inflation and interest rate expectations stemming from the war, and said the correlation between stocks and bonds was now positive.

"This has weighed on multi-asset portfolios with a limited opportunity set for diversification - the risk of a larger 60/40 portfolio drawdown (a 'Balanced Bear') has increased," the bank wrote.

The pain in bonds comes at a time when other safe havens have also started to falter for investors.

Gold, which has largely been propped up by speculative hype and investors' expectations for rate cuts in the coming year, has plummeted 14% from its record high in late January.

Goldman said it was recommending that investors increase allocations to defensive, high-quality stocks and "selective safe assets" to account for the risk of stagflation, a dynamic in which growth slows while inflation soars.