Rising interest rates and inflation have upended investing

[SeattleCPA]

Okay, one other article in this week's economist to recommend... Probably behind a payroll for most folks. But if you walk by a news agent while commuting or while traveling, this week's print issue would be good to grab for this article and then that other one I mentioned.

Here's the second article: https://www.economist.com/briefing/2022/12/08/rising-interest-rates-and-inflation-have-upended-investing

And the TLDR summary:

1. Higher inflation ends the near-zero interest rate world
2. Investors now need to design portfolios that "plan for" inflation (like they used to have to do)
3. The classic 60/40 portfolio is "back in business."
4. Young investors may get good returns going forward.
5. People close to retirement or who just bought a house with a mortgage? Yeah, need to be careful.
6. International should work well for US investors.

My opinion, they make compelling case. And I don't always think that. FWIW...

[NorCal]

That was a good read, and thanks for sharing.  The last time people had to think like this was a couple decades before I started my investing journey in 2007.

I had some similar revelations when I was helping a 20-something family friend think about whether it was a good time to buy her first starter home.  Essentially, the assumptions were that waiting would likely provide an opportunity for lower prices, but the monthly payments would still be higher.  It's logical, but not something I'd had to think about much before.  It only made sense when thinking about it as a house and not an investment.  That's a pretty massive change. 

[SeattleCPA]

That was a good read, and thanks for sharing.  The last time people had to think like this was a couple decades before I started my investing journey in 2007.

I had some similar revelations when I was helping a 20-something family friend think about whether it was a good time to buy her first starter home.  Essentially, the assumptions were that waiting would likely provide an opportunity for lower prices, but the monthly payments would still be higher.  It's logical, but not something I'd had to think about much before.  It only made sense when thinking about it as a house and not an investment.  That's a pretty massive change.

One other thing worth mentioning in response to your comment above. I found it interesting the Economist's writers were also saying, "and gosh there are now reasonable ways for individual investors to use commodities to hedge some inflation.

I have not thought about that a lot. I'm programmed by history to think that anything with the word "Commodity" or "Commodities" is likely to result in disaster. And then having to stay after school for detention. But I mention because it's interesting to mull over the idea that we'll have different financial tools available this time to manage an investment environment with inflation.

Last go around, in retrospect, you wanted to leverage up with rental real estate using fixed low-interest-rate mortgages supplied by some S&L... but not get caught in the Volker steamroller.

BTW it's interesting to also think about which of the standard asset allocation formulas make sense if the Economist is right.

[erp]

I read this article today and wanted to talk about it! Agree that it was a pretty sensible read, but I typically think that of the Economist's coverage, so I'm biased.
I was really interested by their comment that index investing was likely to keep trucking along while private equity/hedge funds were going to get creamed (certainly lines up with the typical forum view).

Thanks for sharing!

[MustacheAndaHalf]

2. Investors now need to design portfolios that "plan for" inflation (like they used to have to do)
3. The classic 60/40 portfolio is "back in business."

It's too early to declare 60/40 back in business, as it failed in 2022.  Stocks lost 16%, and bonds lost 12%.  While that is historically rare, there's also an elevated risk it continues into 2023.

You could invest internationally, although it may be too late in some cases.  iShares MSCI United Kingdom ETF (EWU) is just -3% YTD after a recent +10% bounce in the past month.  Their stocks are more value oriented.

I suspect dividend stocks will make a comeback.  CNBC's Halftime Report had a money manager who had beaten the market by double digits this year, using a dividend stock strategy - it turns out, his performance was +1% YTD.  As investors see that dividend ETFs have outperformed, I expect more of them to chase performance.  It might be a good time to strike up conversations with relatives over the age of 70 who remember dividend investing back in the 1970s-1980s.

[rpr]

5. People close to retirement or who just bought a house with a mortgage? Yeah, need to be careful.

What is close to retirement - 1,3,5,10 years? I don't have access to the magazine but may I ask if you can summarize the concern. I'm kinda in this position at the moment. :) Thanks.

[Tigerpine]

5. People close to retirement or who just bought a house with a mortgage? Yeah, need to be careful.

What is close to retirement - 1,3,5,10 years? I don't have access to the magazine but may I ask if you can summarize the concern. I'm kinda in this position at the moment. :) Thanks.

Check to see if your library has digital access to the Economist.  You may be able to read the article yourself for free.

[SeattleCPA]

5. People close to retirement or who just bought a house with a mortgage? Yeah, need to be careful.

What is close to retirement - 1,3,5,10 years? I don't have access to the magazine but may I ask if you can summarize the concern. I'm kinda in this position at the moment. :) Thanks.

There's only a paragraph of commentary about this issue. But in a nutshell, the authors say that someone close to retirement doesn't really have years and years (or decades and decades) to recover from their losses through better returns. Especially if they were loaded up with bonds.

I would interpret the authors words to mean that you and I want to run the numbers (or update the numbers) for your and my specific situation.

For example, if you redo or recheck your financial plan using your new (beat up) portfolio balances, that'll let you see where you are. You may not be in too bad of shape or much different than you thought.

An example with round numbers to illustrate:

Say someone planned to retire with $1,000,000 and draw $40,000. Historically, that 4% safe withdrawal was supposed to work. But a person could have easily said, "gosh with CAPE so high and real "riskless" interest rates nearly zero... yikes, I'm going to use a 3.5% withdrawal rate... so $35,000."

With the portfolio down to (say) $850,000? I think a 4% withdrawal rate maybe makes a lot more sense? True, the 4% is on the $850,000. So it's $36,000. But that's about what someone may have been thinking?

[SeattleCPA]

I read this article today and wanted to talk about it! Agree that it was a pretty sensible read, but I typically think that of the Economist's coverage, so I'm biased.
I was really interested by their comment that index investing was likely to keep trucking along while private equity/hedge funds were going to get creamed (certainly lines up with the typical forum view).

Thanks for sharing!

I like the economist a lot too. But I should say that I caught what has to be an error in a recent related article. (Maybe from last week's issue.) They said an 80% bonds and 20% stocks portfolio would support a 4% withdrawal rate through 30 years of retirement. I don't think that's an historically accurate statement (per cFIREsim).

Also just to comment about the indexing stuff. I think their observation is basically investment strategies based on really low interest rates (like leveraged buyouts for private equity) aren't going to work as easily now that interest rates are higher and then now that the discount rates used to value equities are higher too.

Like you, though, I think this is good news or at least not "bad" news to folks building portfolios with index funds.

[MustacheAndaHalf]

I was really interested by their comment that index investing was likely to keep trucking along while private equity/hedge funds were going to get creamed (certainly lines up with the typical forum view).

I haven't seen comparisons on the forum of the S&P 500 vs private equity.  Private equity buys distressed companies, adds value, and sells them.  How is that model supposed to fail when more companies are in deeper distress?

It worked during the 2008 crisis, and has beaten the S&P 500 by several percent for decades.  Do you have data showing private equity underperforms the S&P 500?
https://caia.org/blog/2022/07/20/long-term-private-equity-performance-2000-2021

Or look at what investopedia has to say about it:
"Between 2000 and 2020, private equity outperformed the Russell 2000, the S&P 500, and venture capital."
https://www.investopedia.com/ask/answers/040615/how-do-returns-private-equity-investments-compare-returns-other-types-investments.asp

[NorCal]

One other thing worth mentioning in response to your comment above. I found it interesting the Economist's writers were also saying, "and gosh there are now reasonable ways for individual investors to use commodities to hedge some inflation.

I have not thought about that a lot. I'm programmed by history to think that anything with the word "Commodity" or "Commodities" is likely to result in disaster. And then having to stay after school for detention. But I mention because it's interesting to mull over the idea that we'll have different financial tools available this time to manage an investment environment with inflation.

I can't say I agree with their take on commodities.  While there are lots of new financial instruments linked to commodities, I'm not aware of any that have a place in a long term portfolio.

They're almost universally linked to futures.  Futures are great for hedging or day trading.  But the roll yield will eat you alive in any long term portfolio.

I'm a fan of having a slightly higher exposure to commodity equities than exist in a typical index.  I put 5% of my domestic stocks in VAW (Vanguard Materials ETF) and think that does a better job than adding an ETF based on futures.  I also hold a tiny stake in Newmont Mining, which I view as a superior proxy for gold. 

[JupiterGreen]

5. People close to retirement or who just bought a house with a mortgage? Yeah, need to be careful.

What is close to retirement - 1,3,5,10 years? I don't have access to the magazine but may I ask if you can summarize the concern. I'm kinda in this position at the moment. :) Thanks.

if you drop the url into the wayback machine (the website) you can read it. But essentially the article says that young investors will have time for their 60/40 portfolios to grow. Older investors have seen their larger portfolios drop and may not have enough time to come back from this drop before retirement. As for you personally, you only need to worry about your numbers and if they look good for you to FIRE

Providing the perspective pans out, it sounds like a good direction. I was interested in the part where they mentioned investors are putting more weight on businesses making a profit rather than using cash, does this mean less risky business ventures will find it harder to get financing? Or something else?. Also if someone is feeling kind enough, did I understand it correctly that they are predicting debt is going to be harder to sell? If so, selling debt is one factor that contributed to 2008, no?   

[SeattleCPA]

2. Investors now need to design portfolios that "plan for" inflation (like they used to have to do)
3. The classic 60/40 portfolio is "back in business."

It's too early to declare 60/40 back in business, as it failed in 2022.  Stocks lost 16%, and bonds lost 12%.  While that is historically rare, there's also an elevated risk it continues into 2023.

That article mentions the last time 60/40 failed was 1937. So pretty rare.

To me, it seems unlikely for such a rare event to occur two years in a row. But you never know.

[SeattleCPA]

I was really interested by their comment that index investing was likely to keep trucking along while private equity/hedge funds were going to get creamed (certainly lines up with the typical forum view).

I haven't seen comparisons on the forum of the S&P 500 vs private equity.  Private equity buys distressed companies, adds value, and sells them.  How is that model supposed to fail when more companies are in deeper distress?

That's not the model the economist is talking about, as least in my understanding. They're talking about leveraged buyouts in general. And how the cheap money of the last couple of decades juiced the returns.

E.g., borrow 90% of the money needed to purchase a $1B company... and if firm earns 6% when the lenders only charge you 5%, you earn astronomical returns.

[rpr]

Thanks @SeattleCPA @JupiterGreen and @Tigerpine

It looks like my library does get the Economist but with a delay of a week or so.

I will look for it when it shows up.

[SeattleCPA]

It worked during the 2008 crisis, and has beaten the S&P 500 by several percent for decades.  Do you have data showing private equity underperforms the S&P 500?

David Swensen in Unconventional Success compares private equity to S&P and said (for period he could look at) that S&P 500 beat private equity--and that was before considering the extra risk and illiquidity. The exact quote:

The history of the buyout industry proves the point. For the twenty years ending June 30, 2003, a group of 304 buyout funds tracked by investment consultant Cambridge Associates produced a pooled mean return of 11.5 percent. 20 Over the same period the S&P 500 returned 12.2 percent. Buyout investors incurred greater risk and paid higher fees to achieve inferior results, which hardly represents a description of investment success.

[NorCal]

I was really interested by their comment that index investing was likely to keep trucking along while private equity/hedge funds were going to get creamed (certainly lines up with the typical forum view).

I haven't seen comparisons on the forum of the S&P 500 vs private equity.  Private equity buys distressed companies, adds value, and sells them.  How is that model supposed to fail when more companies are in deeper distress?

That's not the model the economist is talking about, as least in my understanding. They're talking about leveraged buyouts in general. And how the cheap money of the last couple of decades juiced the returns.

E.g., borrow 90% of the money needed to purchase a $1B company... and if firm earns 6% when the lenders only charge you 5%, you earn astronomical returns.

I've done some consulting work for companies owned by Private Equity.  LBO shops are truly screwed.  I think the growth-equity folks will mostly be okay. 

LBO funds use truly massive amounts of debt, and have a couple of other factors that work against them.  A few I can think of:

1.  They're smart about structuring the debt to have different maturities.  I've seen all varieties depending on the company, but you can assume that each company has some layer of debt that needs to be refinanced every year.  At best, rates go up.  At worst, they can't refinance.
2.  They use some very creative accounting.  I won't go so far to call it fraud, but I'll go far enough to say my public company clients wouldn't get away with it.  The gap between the "Adjusted EBITDA" they present to value themselves and their actual income & cash flows is quite large.
3. Cash flows are designed to be razor thin.  Any available cash flow is immediately used to acquire a new business, which includes additional debt.  A simple decrease in revenue or decline in margins could require some pretty rapid debt refinancing.
4.  Increasing costs of debt will have an outsized impact on their valuation models.
5. Something like 90% of PE deals are companies bought and sold between various PE funds.  I think it was the Economist that called this out a few months back.  There is a strong suspicion that the public markets wouldn't value these companies nearly as highly as the private markets are.

[MustacheAndaHalf]

It worked during the 2008 crisis, and has beaten the S&P 500 by several percent for decades.  Do you have data showing private equity underperforms the S&P 500?

David Swensen in Unconventional Success compares private equity to S&P and said (for period he could look at) that S&P 500 beat private equity--and that was before considering the extra risk and illiquidity. The exact quote:

The history of the buyout industry proves the point. For the twenty years ending June 30, 2003, a group of 304 buyout funds tracked by investment consultant Cambridge Associates produced a pooled mean return of 11.5 percent. 20 Over the same period the S&P 500 returned 12.2 percent. Buyout investors incurred greater risk and paid higher fees to achieve inferior results, which hardly represents a description of investment success.

Private equity also trailed the market from 2019-2021, when the S&P 500 doubled in 3 years.  I think the 1990s were an extremely impressive bull market, but I would not count on 12.2% returns from the S&P 500.  The article I referenced shows PE beating the S&P 500 by about 4%/year, compared to the 0.7%/year you cited (both 20 year periods).  Combining the two periods probably favors private equity.

The reason David Swensen became famous was because he moved Yale's Endowment into alternatives like LBO and venture capital, boosting returns (and maybe lowering volatility overal, I forget).

David Swensen recently passed away, but the allocation of Yale's Endowment reflected his decisions up until recently.  They have almost nothing in U.S. equities, and a significant allocation to LBOs (and venture capital).
https://investments.yale.edu/about-the-yio

[MustacheAndaHalf]

I was really interested by their comment that index investing was likely to keep trucking along while private equity/hedge funds were going to get creamed (certainly lines up with the typical forum view).

I haven't seen comparisons on the forum of the S&P 500 vs private equity.  Private equity buys distressed companies, adds value, and sells them.  How is that model supposed to fail when more companies are in deeper distress?

That's not the model the economist is talking about, as least in my understanding. They're talking about leveraged buyouts in general. And how the cheap money of the last couple of decades juiced the returns.

E.g., borrow 90% of the money needed to purchase a $1B company... and if firm earns 6% when the lenders only charge you 5%, you earn astronomical returns.

I've done some consulting work for companies owned by Private Equity.  LBO shops are truly screwed.  I think the growth-equity folks will mostly be okay. 

LBO funds use truly massive amounts of debt, and have a couple of other factors that work against them.  A few I can think of:

1.  They're smart about structuring the debt to have different maturities.  I've seen all varieties depending on the company, but you can assume that each company has some layer of debt that needs to be refinanced every year.  At best, rates go up.  At worst, they can't refinance.
2.  They use some very creative accounting.  I won't go so far to call it fraud, but I'll go far enough to say my public company clients wouldn't get away with it.  The gap between the "Adjusted EBITDA" they present to value themselves and their actual income & cash flows is quite large.
3. Cash flows are designed to be razor thin.  Any available cash flow is immediately used to acquire a new business, which includes additional debt.  A simple decrease in revenue or decline in margins could require some pretty rapid debt refinancing.
4.  Increasing costs of debt will have an outsized impact on their valuation models.
5. Something like 90% of PE deals are companies bought and sold between various PE funds.  I think it was the Economist that called this out a few months back.  There is a strong suspicion that the public markets wouldn't value these companies nearly as highly as the private markets are.

Personally I'm investing 1/3rd of my NW in private equity, but none of it LBO.  I suspect you're right about PE (and VC) company valuations.  Less money flowing in means fewer funding rounds, and those are the primary determinent of price.

I'd also be interested if you can point to public data about LBO performance.  I couldn't find any in a brief search.

[SeattleCPA]

Thanks @SeattleCPA @JupiterGreen and @Tigerpine

It looks like my library does get the Economist but with a delay of a week or so.

I will look for it when it shows up.

@rpr I should have thought to mention this available resource in response to your question. That Vanguard outlook paper that just came out gives (I think) reasonable estimates of returns they expect for various asset classes:

https://investor.vanguard.com/investor-resources-education/news/vanguard-economic-and-market-outlook-for-2023-global-summary

Note that the returns are nominal. A range like 7% to 9% includes 3% inflation.

[SeattleCPA]

Personally I'm investing 1/3rd of my NW in private equity, but none of it LBO.  I suspect you're right about PE (and VC) company valuations.  Less money flowing in means fewer funding rounds, and those are the primary determinent of price.

I'd also be interested if you can point to public data about LBO performance.  I couldn't find any in a brief search.

First, let me say that I have no problem with someone putting money into private equity. (Full disclosure: I've done so myself. And would again.) Also I have talked here recently about the research (Capitalists in the Twenty-first Century) that seems to suggest one form of private equity, ownership of small pass-through entities, is really the most common route to joining the top one percent or the top point one percent.

But some comments or remarks to move the ball forward.

So challenged by statement that you've looked but can't find good data on private equity returns, I thought, "oh gosh, that data must be available at least from the economists researching stuff like this. But alas when I search "private equity NBER" there is very little. A bit. But not much. Which is interesting.

I did find this interesting and useful "lay" discussion from NYU publication: https://theeconreview.com/2022/06/10/does-private-equity-outperform-public-markets/ It appears to say that PE maybe slightly beats S&P though probably not enough to justify the higher risk. And then there are questions about whether the PE data is even precise and accurate enough to compare to public company returns. (This is contrary to the blog post from Stephen Nesbitt you referenced.)

BTW it's possible you may recall my in-forum public enthusiasm for investments in housing that followed the "rate of return of everything" research. (There are several threads.) That enthusiasm mostly boiled down to low correlation between housing and stocks and then less volatility in housing. But as some of you pointed out, that lower volatility may have just reflected less frequent measurement? Or maybe a market when people don't or don't have to admit the value of their asset has declined? I mention because it's possible that same weirdness affects the PE data that is available?

A final comment which you know, @MustacheAndaHalf , but others may not. So I share here. David Swensen wrote two books. Unconventional Success (which is a GREAT book we all should read IMO) and Pioneering Portfolio Management (another good book for active investment managers). In "Pioneering" he digs into the details of returns from alternative assets like PE, hedge funds, etc. And he says (and I would say proves) that on average these alternative asset categories fail investors because their median returns look pretty modest compared to public equities. Swensen shows in "Pioneering" in a little chart that an investor needs to be in the top quartile to get the good returns. And then he says Yale gets access to those investments. Other big investors ( Gates Foundation?) do. But "smaller" and even average PE investors won't. I mention all this because I kinda wonder if this doesn't explain things like the disconnect between Swensen and Nesbitt. BTW Swensen also says this in "Unconventional" but I can't find the chart or quantitative details (like a table.)

[SeattleCPA]

I was really interested by their comment that index investing was likely to keep trucking along while private equity/hedge funds were going to get creamed (certainly lines up with the typical forum view).

I haven't seen comparisons on the forum of the S&P 500 vs private equity.  Private equity buys distressed companies, adds value, and sells them.  How is that model supposed to fail when more companies are in deeper distress?

That's not the model the economist is talking about, as least in my understanding. They're talking about leveraged buyouts in general. And how the cheap money of the last couple of decades juiced the returns.

E.g., borrow 90% of the money needed to purchase a $1B company... and if firm earns 6% when the lenders only charge you 5%, you earn astronomical returns.

I've done some consulting work for companies owned by Private Equity.  LBO shops are truly screwed.  I think the growth-equity folks will mostly be okay. 

LBO funds use truly massive amounts of debt, and have a couple of other factors that work against them.  A few I can think of:

1.  They're smart about structuring the debt to have different maturities.  I've seen all varieties depending on the company, but you can assume that each company has some layer of debt that needs to be refinanced every year.  At best, rates go up.  At worst, they can't refinance.
2.  They use some very creative accounting.  I won't go so far to call it fraud, but I'll go far enough to say my public company clients wouldn't get away with it.  The gap between the "Adjusted EBITDA" they present to value themselves and their actual income & cash flows is quite large.
3. Cash flows are designed to be razor thin.  Any available cash flow is immediately used to acquire a new business, which includes additional debt.  A simple decrease in revenue or decline in margins could require some pretty rapid debt refinancing.
4.  Increasing costs of debt will have an outsized impact on their valuation models.
5. Something like 90% of PE deals are companies bought and sold between various PE funds.  I think it was the Economist that called this out a few months back.  There is a strong suspicion that the public markets wouldn't value these companies nearly as highly as the private markets are.

@NorCal great info. Thank you for sharing. And I am not at all surprised.

The only thing I'd wonder is whether the "growth" guys are really still safe. If the discount rate used to value their assets has gone way up, seems like (temporarily) blows up their investment formula too? (This was point made in Economist but also obviously a basic application of "net present value" formula.)

P.S. I agree with you about commodities.

[MustacheAndaHalf]

Personally I'm investing 1/3rd of my NW in private equity, but none of it LBO.  I suspect you're right about PE (and VC) company valuations.  Less money flowing in means fewer funding rounds, and those are the primary determinent of price.

I'd also be interested if you can point to public data about LBO performance.  I couldn't find any in a brief search.

I did find this interesting and useful "lay" discussion from NYU publication: https://theeconreview.com/2022/06/10/does-private-equity-outperform-public-markets/ It appears to say that PE maybe slightly beats S&P though probably not enough to justify the higher risk. And then there are questions about whether the PE data is even precise and accurate enough to compare to public company returns. (This is contrary to the blog post from Stephen Nesbitt you referenced.)

That report article references a report by McKinsey, where I found five asset classes compared by IRR.  The mckinsey.com link is 250+ characters, here is that page 14 performance data:
tinyurl.com/p98ux67h

They measured performance from 2008 to Sept 2021, finding a +19.5% median return for private equity (versus 30.5% for the top quartile).  US markets returned 10.5%, while international lagged at +2.9% (portfolio visualizer data).  There's also an argument to be made for having REITs (8% over that period, 0.74 correlation to S&P 500) versus international (0.89 correlation).

First, let me say that I have no problem with someone putting money into private equity. (Full disclosure: I've done so myself. And would again.)
...
BTW it's possible you may recall my in-forum public enthusiasm for investments in housing that followed the "rate of return of everything" research. (There are several threads.) That enthusiasm mostly boiled down to low correlation between housing and stocks and then less volatility in housing. But as some of you pointed out, that lower volatility may have just reflected less frequent measurement? Or maybe a market when people don't or don't have to admit the value of their asset has declined? I mention because it's possible that same weirdness affects the PE data that is available?

A final comment which you know, @MustacheAndaHalf , but others may not. So I share here. David Swensen wrote two books. Unconventional Success (which is a GREAT book we all should read IMO) and Pioneering Portfolio Management (another good book for active investment managers). In "Pioneering" he digs into the details of returns from alternative assets like PE, hedge funds, etc. And he says (and I would say proves) that on average these alternative asset categories fail investors

I assume public REITs have shorter pricing delays that private real estate, and those public REITs show a low correlation to other public stocks over decades.  I suspect the lower correlation of private real estate could be real.

The record inflows into PE shown in the NYU article are interesting, but I suspect public markets had huge inflows as well - when the S&P 500 doubles from 2019-2021, that attracts investors.

I read David Swensen's books years ago as a passive investor, but maybe I should re-read now that my investing has changed.  In this talk from ~2017, David Swensen mentions that the average hedge fund offers a multiple on invested capital (MOIC) of 1.4x or 1.5x, and he prefers investments with 2.0x MOIC or higher (and high IRR numbers). 
https://www.youtube.com/watch?v=lmHgg3-REl0

Over 2020-2022 YTD I've beaten the market by double digits each year, but I keep expecting that outperformance to end.  My motivation for hedge fund investing is to pay someone else to beat the market for me.  The S&P 500 has returned roughly 10%/year, which becomes 1.6x MOIC (+60%) after 5 years and 2.6x MOIC (+160%) after 10 years.  If my largest hedge fund investments don't provide significant outperformance compared to that, I would view it as a failure.  I also modeled ideal market timing of a crash (+50%) replacing the first two years, and still decided to invest in hedge funds.

[vand]

I don't know if I'd say they have "upended" investing; imo it's a return to how investing is meant to work - and has worked for most of history.

[NorCal]

I was really interested by their comment that index investing was likely to keep trucking along while private equity/hedge funds were going to get creamed (certainly lines up with the typical forum view).

I haven't seen comparisons on the forum of the S&P 500 vs private equity.  Private equity buys distressed companies, adds value, and sells them.  How is that model supposed to fail when more companies are in deeper distress?

That's not the model the economist is talking about, as least in my understanding. They're talking about leveraged buyouts in general. And how the cheap money of the last couple of decades juiced the returns.

E.g., borrow 90% of the money needed to purchase a $1B company... and if firm earns 6% when the lenders only charge you 5%, you earn astronomical returns.

I've done some consulting work for companies owned by Private Equity.  LBO shops are truly screwed.  I think the growth-equity folks will mostly be okay. 

LBO funds use truly massive amounts of debt, and have a couple of other factors that work against them.  A few I can think of:

1.  They're smart about structuring the debt to have different maturities.  I've seen all varieties depending on the company, but you can assume that each company has some layer of debt that needs to be refinanced every year.  At best, rates go up.  At worst, they can't refinance.
2.  They use some very creative accounting.  I won't go so far to call it fraud, but I'll go far enough to say my public company clients wouldn't get away with it.  The gap between the "Adjusted EBITDA" they present to value themselves and their actual income & cash flows is quite large.
3. Cash flows are designed to be razor thin.  Any available cash flow is immediately used to acquire a new business, which includes additional debt.  A simple decrease in revenue or decline in margins could require some pretty rapid debt refinancing.
4.  Increasing costs of debt will have an outsized impact on their valuation models.
5. Something like 90% of PE deals are companies bought and sold between various PE funds.  I think it was the Economist that called this out a few months back.  There is a strong suspicion that the public markets wouldn't value these companies nearly as highly as the private markets are.

@NorCal great info. Thank you for sharing. And I am not at all surprised.

The only thing I'd wonder is whether the "growth" guys are really still safe. If the discount rate used to value their assets has gone way up, seems like (temporarily) blows up their investment formula too? (This was point made in Economist but also obviously a basic application of "net present value" formula.)

P.S. I agree with you about commodities.

In terms of growth equity being safe, I'm using that in relative terms and not absolute terms.  I see them as being less screwed than everyone else, but not necessarily safe.

A lot of it is business and industry specific.  I've worked with a few companies in places like health care that have high degrees of regulatory capture and nearly zero competition.  PE companies love those businesses, and I have no concerns about the returns on those funds.  And there are still other industries out there that will grow through a recession.

More competitive industries will probably see a lot more Chapter 11 bankruptcies than past cycles.  There are a decent number of fundamentally sound companies out there that have been loaded up with some debt loads that make no sense in a higher interest rate environment.  I'm working with a company now that shows their investors $40M/yr in Adjusted EBITDA for valuation purposes, but has negative $50M/yr in free cash flow.  They failed to flip the company earlier this year when the markets got jittery.  It'll be interesting to see what they end up doing.