The start of 2025 has brought a sharp uptick in equity drawdown risks, with Goldman Sachs estimating a near 30% probability of market corrections, fueled by surging policy uncertainty and shifting inflation dynamics.

In a note published Wednesday, analysts Andrea Ferrario and Christian Mueller-Glissmann highlighted heightened risks stemming from rising inflation pressures, trade tensions and political uncertainty ahead of Donald Trump's second presidential term, set to start on Jan. 20, 2025.

The analysts indicated that these factors could lead to deeper market volatility and weaker forward returns for equities.

What Is Driving The Increased Risk?

Goldman's framework shows the probability of an equity drawdown has jumped to nearly 30%, a significant rise from levels seen in 2024. Historically, when drawdown risk crosses this threshold, markets have experienced lower returns and, in some cases, severe corrections.

Goldman indicates that extreme outcomes are more likely if the probability exceeds 35%.

One of the primary drivers of this heightened risk is the resurgence of inflation, which has shifted from negative to positive. This trend is particularly concerning for investors, as inflation could erode profit margins and limit central bank interventions in the event of market turmoil.

Policy uncertainty has also climbed sharply. “Global trade and the risk of U.S. tariffs have been at the epicenter of this surge in uncertainty, with measures of trade policy uncertainty spiking above their 2018-2019 highs,” the analysts wrote.

Although the macroeconomic environment remains broadly supportive of equities, Goldman cautioned that market sentiment could deteriorate rapidly under adverse scenarios.

A combination of geopolitical risks, inflation surprises and corporate earnings misses could create a perfect storm for investors, leading to sharper corrections.

Hedging Strategies For Uncertain Times

Goldman recommended hedging strategies to protect portfolios in this uncertain environment.

“We like shorter-dated S&P 500 put spreads to hedge near-term correction risk due to negative growth surprises, policy uncertainty into the U.S. presidential inauguration, or misses in the January earnings season,” the note said.

For investors worried about more severe economic downturns, longer-dated S&P 500 puts may offer better protection. “After the recent hawkish repricing, longer-dated S&P 500 puts would likely also benefit from falling front-end rates in the event of severe growth shocks,” the analysts added.

The note also highlighted hybrid instruments, which combine equity and currency exposures, as tools to hedge against rising rates and trade-related risks.

Goldman specifically recommended “S&P 500 down/EURUSD down hybrids” and “S&P 500 down/US 10y up double digitals” as effective hedges.

The former derivative is ideal for scenarios where both the equity market and the euro decline simultaneously, potentially in reaction to tariffs policies, while the latter works well in environments where equity markets are under pressure and bond yields rise as a result of inflation concerns or expectations of higher interest rates.

Since Trump’s election victory in November, the U.S. dollar index — as tracked by the Invesco DB USD Index Bullish Fund ETF UUP — has risen by over 5%. During the same period, blue-chip stocks, tracked by the SPDR Dow Jones Industrial Average ETF DIA have shown a flat performance.

Yields on 30-year Treasury bonds are hovering near 4.95%, climbing over 100 basis points since mid-September 2024.

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