3 investment strategies for dealing with stagflation risks, according to analysts

Fears of stagflation have plagued investors for the past few months as prices begin to rise in an economy that has not quite taken off. However, investors can employ some strategies to circumvent these risks, analysts say.

An economy experiencing stagflation is stagnant activity and accelerating inflation at the same time. This phenomenon was first recognized in the 1970s when an oil shock resulted in a prolonged period of higher prices but sharply declining GDP growth.

Similarly, energy prices have skyrocketed recently, which has contributed to inflation fears.

In an October report, Morgan Stanley found that stagflation risks could attract investor attention and could result from a “supply shock”.

“The disruption in global supply chains has created bottlenecks in areas such as energy and semiconductors. These situations could drag on into next year, which would likely keep inflationary pressures high in the short term, ”wrote Morgan Stanley analysts.

Stagflation poses a problem for economic policymakers, as measures to contain inflation – such as wage and price controls or a contractionary monetary policy – can further increase unemployment.

Goldman Sachs also warned in October that stagflation could be bad for stocks.

Below are some approaches that analysts suggest to deal with stagflation risks.

1. A “barbell” strategy

According to Morgan Stanley, investors can pursue a barbell strategy and own cheaply priced stocks with high free cash flow and dividends. Free cash flow is a measure of profitability that represents the amount of money a business generates after considering outflows to support spending.

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Earlier this year, the investment bank said a barbell strategy can hedge against market setbacks. This strategy involves overweighting two different groups of stocks to hedge against uncertainty about the next market move. The barbell approach takes the two extremes of risky and risk-free investing to strike a balance between risk and reward.

2. Bet on “price setters” and avoid growth stocks

One approach, according to Rob Mumford, emerging market equity investment manager at Gam Investments, would be to invest in upstream manufacturing companies.

“The key is to be with the price setters where you don’t really want to be downstream,” he said.

Upstream refers to input materials needed to manufacture goods, while downstream operations are those that are closer to the customer, where products are made and sold.

An example of an upstream production would be semiconductor companies, Mumford told CNBC’s “Squawk Box Asia” on Tuesday. Chip prices have skyrocketed this year due to a global scarcity affecting everything from cars to consumer electronics.

What investors should avoid, Mumford cautioned with growth stocks.

“I think growth stocks will be vulnerable, especially when inflation starts to be above expectations,” he said.

Growth stocks are stocks that are expected to grow well above the market average.

3. Stick with value and cyclical stocks for now

Morgan Stanley says value and cyclical stocks benefit most when inflation expectations rise. Value stocks appear to be trading below what analysts believe is worth. Cyclical stocks tend to follow business cycles and rise and fall in line with macroeconomic conditions.

“Should stagflation risk continue to develop, a reversal trading strategy could stand out in terms of profitability,” added the investment bank. “This would mean buying last month’s worst price stragglers and expecting a price reversal the following month.”

– CNBC’s Jesse Pound contributed to this report.