2022 has been a difficult year for multi-asset portfolios as bond yields have risen in reaction to higher inflation. While an end to policy tightening may be a few months away, a well-diversified portfolio of bonds and large-cap equities can now enjoy a period of higher estimated returns.
Fixed income markets were unprepared for a period of higher inflation and bond investors endured their worst year since the early 70s. While central banks were slow to respond, they have now regained control of prices. Bond yields have risen meaningfully in 2022 and now compensate investors for inflationary risk.
Our estimated return framework for bonds uses prevailing yields adjusted for expected defaults. Gilts and hedged global government bonds now offer 3% plus returns, having started 2022 with minimal return expectations.
High yield bonds now yield 9-10%. We have cautiously assumed that around 16% of the index will default over the next three years, which represents the entire cohort of the lowest rated issuers. Adjusting for recovery, we get to an estimated return of 7.2%, which is the largest improvement of any asset class.
Within alternatives, we have seen a reduction in estimated returns for global infrastructure. The asset class has done well in 2022 and a higher valuation leads to a lowering of estimated returns.
We anticipate a slowdown in global economic activity in the first half of 2023, before a recovery late in the year. 2022 earnings have surprised positively as companies in a variety of sectors have delivered better revenues through higher prices. While corporate earnings will come under pressure, we expect earnings growth to resume in the second half. Small-cap equities, emerging markets and value-tilted strategies could suffer severe drawdowns during the recession, and we have taken steps to mitigate this risk.
Estimated returns for equities are higher than at the start of the year. UK-mid and large-cap equities look particularly attractive due to their depressed valuations. While valuations matter over the long term, there are periods when actual returns can diverge from expectations.
The challenging market backdrop has caused many to seek solace in high-cost alternative strategies that have a chequered track record of protecting downside. We believe that the rise in bond yields has created a sound footing for traditional, low-cost investment approaches and we have embraced this change whole heartedly.
Our investment approach is data-driven, forward looking, and focused on the long-term. This allows us to look through the here and now and focus on opportunities as they become available. We are excited by the opportunity set we see ahead of us.
At Albemarle Street Partners we use forward looking estimated return models that use yield and valuation-based frameworks for estimated asset class returns. Forecasts for estimated returns are based on backwards-looking information and there is no guarantee that future events will not lead to a different path of returns. While valuations can serve as a useful indicator of long-term asset prices, actual returns may vary. Past performance is not a guide to future performance. The price of investments can go down as well as up and are not guaranteed.