Higher inflation is an underpriced risk and investors should hedge with these 5 assets, BlackRock says

• Investors are underestimating the risk of higher inflation, according to BlackRock's Gargi Chaudhuri.
• The firm favors small caps, value stocks, banks, inflation linked bonds, and diversified commodities as hedges.
• Chaudhuri said supply-chain disruptions will drive inflation in the near-term, then rising debt and the Fed's policy will drive medium-temr inflation.

Investors are underestimating the risk of higher inflation, according to BlackRock's Gargi Chaudhuri.

In a Wednesday note, the head of iShares investment strategy for the Americas said that investors should look to hedge against coming inflation using a multi-asset approach. Chaudhuri favors small caps, value stocks, banks, inflation linked bonds, and diversified commodities.

"While we don't expect runaway inflation of the 1970s because of the impact of technology and demographics, we still think higher inflation is an underpriced risk in the markets," she said.

One debate within the inflation conversation is whether inflationary pressures will be sustained or transitory. Investors fear that sustained inflation could force the Fed to change its policy sooner than expected, though chair Powell has reiterated that inflationary pressures will be transitory.

Chaudhuri also said inflation will be transitory, but that doesn't mean it's not a risk for investors.

In fact, the strategist said that inflation is here to stay for both the short-term and the medium-term.

Inflation fears came in full focus last month when the April CPI report showed prices rose 4.2% year over year, versus 3.6% expected, in the largest increase since 2008. Core PCE also was higher than expected.

"The April CPI and PCE surprise represents the beginning of a transitory inflationary period, as supply constraints and surging demand will likely keep the medium-term inflation outlook elevated," she said.

Chaudhuri added that in the short-term, supply chain disruptions and the economic re-opening will drive inflation higher. However, those effects will only be transitory in nature as supply will eventually come back online to keep pace with demand. In the near term, supply bottlenecks in the auto sector and commodities will drive volatility.

In the medium term, inflation will be driven less by supply chain disruptions and more by rising production costs as companies rethink supply chains, the Fed's new policy framework that allows inflation to overshoot, and rising debt levels that will make it harder for central banks to lean too hard against inflation, the strategist said.