Markets Are Underestimating Inflation Again, BlackRock and Fidelity Warn

(Bloomberg) — Some of the world’s largest asset managers such as BlackRock Inc., Fidelity Investments and Carmignac are warning markets are underestimating both inflation and the ultimate peak of US rates, just like a year ago.

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The stakes are immense after Wall Street almost unanimously underestimated inflation’s trajectory. Global stocks saw $18 trillion wiped out, while the US Treasury market suffered its worst year in history. And yet, going by inflation swaps, expectations are again that inflation will be relatively tame and drop toward the Federal Reserve’s 2% target within a year, while money markets are betting the central bank will start cutting rates.

That’s set markets up for another brutal ride, according to Frederic Leroux, a member of the investment committee and head of the cross asset team at €44 billion ($47 billion) French asset manager Carmignac, since worker shortages are likely to fuel higher-than-expected inflation.

“Inflation is here to stay,” said Leroux in a phone interview. “After the crisis central bankers thought they could decide the level of interest rates. In the past two years they realized they don’t: inflation does.”

He added that one of the biggest mispricings in the market today is the expectation that inflation will come down to 2.5% next year, before adding that the world is entering a macroeconomic cycle comparable to between 1966 and 1980. That period saw energy shocks that drove US inflation into double digits twice.

“We have to live in a very different environment than before,” Leroux said. Gold, Japanese stocks and trusty, steady companies will make a comeback, in his view, as negative real yields persist and central banks will be unwilling to inflict too much pain.

On Thursday, Fed officials reiterated the central bank’s hawkish stance with comments that sought to dispel hopes for an imminent reversal in the policy path. On Friday the European Central Bank’s Chief economist Philip Lane echoed that sentiment, saying price pressures will remain elevated even if surging energy costs ease.

Analysts at BlackRock’s Investment Institute also see high inflation persisting, with little hope that a recession will spur the Fed to cut rates. Instead, they expect the Fed to taper its outsized hikes into smaller ones as the pain of the economic slowdown becomes clear, even if inflation stays above the bank’s 2% target.

“Central banks are unlikely to come to the rescue with rapid rate cuts in recessions they engineered to bring down inflation to policy targets. If anything, policy rates may stay higher for longer than the market is expecting,” a team of analysts including Jean Boivin, the head of the Institute, wrote last week. BlackRock is underweight developed market equities and it prefers investment-grade credit to long term government bonds.

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Fidelity Investments’ director of global macro Jurrien Timmer told Bloomberg that inflation remains a key risk to markets as the Fed has repeatedly made it clear that it wants to see the measure come down all the way to the 2% target, not just a slowdown in price growth.

Not all funds agree of course. Dutch asset manager Robeco, with €246 billion under management, takes the view that 2023 will be the peak for rates, the dollar and also inflation. This is mainly because of its expectations for a recession and policy makers’ inability to engineer a soft landing, which it thinks will spark rate cuts.

But Carmignac’s Leroux said the market’s focus on the Fed’s potential pivot is “a sideshow,” as there will be a point when investors realize that inflation is stickier than they’d thought.

“At some point the market will have to understand that more rate hikes are coming,” he said.