Don't count on stocks having bottomed out yet – they could fall another 25% if further Fed tightening fuels a severe downturn, Goldman Sachs warns

• Stocks have failed to price in the worst-case economic downturn next year, Goldman Sachs said.
• Aggressive Federal Reserve tightening in 2023 would make a recession more likely, according to the bank.

Stocks haven't bottomed out yet, and investors are underestimating the risk of a deep recession, Goldman Sachs warned Tuesday.

The bank's strategists said that a severe economic downturn could see the benchmark S&P 500 index fall to 2,888 points, or 25% below its level as of Tuesday's closing bell.

"The broader case for US equities does not look very strong and the normal conditions for an equity trough are not clearly visible yet," a team led by Goldman's global head of foreign-exchange strategy, Kamakshya Trivedi, said in a research note.

Markets have fretted about a potential recession ever since the Federal Reserve started raising interest rates in March in a bid to tame red-hot inflation.

The US central bank hiked rates by a hefty 75 basis points at its June, July, and September meetings, which has weighed on stock prices.

Goldman said the S&P 500 has likely priced in further hikes in November and December – but that it hasn't acknowledged the full likelihood of the Fed's tightening campaign continuing into 2023.

"The Fed may need to signal that tightening could extend properly into 2023," Trivedi's team said.

September's Consumer Price Index report showed that inflation was running at a four-decade high of 8.2% – meaning the Fed hasn't yet managed to bring the rate of price rises anywhere close to its 2% target.

That might force the central bank to continue raising rates into next year, which would increase the risk of a recession, Goldman said.

Soaring bond yields and the ongoing war in Ukraine could also weigh on stocks, according to the bank.

Yields on 10-year US Treasury notes have jumped over 250 basis points to 4.065% year-to-date, meaning it has become more expensive for companies to borrow cash.

Meanwhile, many strategists have voiced concern over a potential escalation of the ongoing conflict between Russia and Ukraine, which could drive oil prices higher.

Rising energy prices would likely cause both industrial production and growth to fall, with the International Energy Agency warning that a sharp crude rally could tip the global economy into a recession.

"US equity valuations do not yet offer a historically large premium to the real returns on offer from bonds and cash, particularly given significant downside if a proper recession occurs or geopolitical risks in Ukraine or elsewhere intensify," Goldman said.

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