How to invest around stagflation, the risks of inflation, analysts say

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A view from a gas station shows gas prices over $ 4, in Arlington-Virginia, United States, on October 30, 2021.

Yasin Ozturk | Anadolu Agency | Getty Images

Fears of stagflation have plagued investors in recent months as prices begin to rise in an economy that has not yet picked up the pace. But investors can adopt some strategies to circumvent these risks, analysts say.

An economy that is experiencing stagflation is one that is simultaneously experiencing stagnant activity and accelerating inflation. This phenomenon was first recognized in the 1970s, when an oil shock led to a long period of higher prices but with a sharp decline in GDP growth.

Likewise, energy prices have risen recently, contributing to inflation fears.

In an October report, Morgan Stanley noted that stagflation risks are attracting the attention of investors and could result from a “supply shock”.

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

Stagflation poses a problem for policy makers because measures to curb inflation – such as wage and price controls or tight monetary policy – can further increase unemployment.

Goldman Sachs also warned in October that stagflation could be detrimental to equities.

Below are some approaches analysts suggest investors can take to address stagflation risks.

1. A “balance wheel” strategy

Morgan Stanley said investors can adopt a balance-wheel strategy and own low-cost stocks with high cash flow and free dividends. Free cash flow is a measure of profitability, which represents the amount of cash a business generates after accounting for outflows to support the expense.

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Earlier this year, the investment bank said a barbell strategy can protect itself against market downturns. This strategy involves being overweight on two distinct groups of stocks to protect against uncertainty about the market’s next move. The balance wheel approach goes for the two extremes of high-risk and risk-free investing in an attempt to find a balance between risk and reward.

2. Choose “pricing they set” and avoid growing stocks

One approach would be to invest in companies in upstream manufacturing according to Rob Mumford, an investment manager of emerging markets equities at Gam Investments.

“The key is to be in pricing, where you don’t really want to be downstream,” he said.

Upstream refers to the input materials needed to produce goods, while downstream operations are those closest to customers, where products are made and distributed.

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

As for what investors should avoid, Mumford urged caution on rising stocks.

“I think growth stocks will be vulnerable, particularly if inflation starts to exceed expectations,” he said.

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

3. Stick to value and cyclical stocks for now

Morgan Stanley said value and cyclical stocks benefit most when inflation expectations rise. Value stocks are those that appear to be trading below what analysts think they are worth. Cyclical stocks tend to follow business cycles, rising and falling in tandem with macroeconomic conditions.

“If the risk of stagflation continues to emerge, a ‘reversal trading’ strategy could stand out in terms of profitability,” added the investment bank. “This would involve buying the worst price delays from last month and expecting a price reversal in the following month.” ‘

– CNBC’s Jesse Pound contributed to this report.

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