LONDON (MarketWatch) — Deflation fears have taken a firm grip on Europe. Here’s how you can invest your money, now that fresh data has signaled inflation is on track to getting dangerously cool in the euro zone.

Inflation data for the currency union released Friday showed an unexpected fall in January to 0.7%. As analysts had forecast no change at 0.8% or slight increase to 0.9%, the disappointing data could push the European Central Bank to try further easing measures in the next six months.

Mario Draghi, President of the European Central Bank. Reuters

After all, just like the Federal Reserve’s Ben Bernanke, the ECB’s Mario Draghi and his fellow policy makers are mindful of how damaging Japan’s long period of deflation was to its economy and employment. As Christine Lagarde, managing director of the International Monetary Fund, said earlier in January: “If inflation is the genie, then deflation is the ogre that must be fought decisively.”

For stock investors, deflation or falling inflation (disinflation) is generally not a great scenario for higher returns. But more easing could lead to new investment opportunities in certain sectors — autos and beaten-down local banks could be the way to go, and even the euro, too. In other words, investments that would benefit from the expected increased stimulus from the ECB.

“I prefer those firms that are exposed to growth in the euro zone, which are some of the auto companies and local banks. UniCredit UCG, -3.12% in Italy, Bankinter BKT, -3.64% in Spain and Commerzbank CBK, -2.32% in Germany will respond well to more stimulus. The markets have been overly concerned about those,” said Colin McLean, managing director at SVM Asset Management.

Finding value in European stocks has gotten trickier over the past year. Even as deflation worries bubble in the background, the main indexes have been on a tear. The Germany DAX 30 index DAX, -0.69% earlier in January climbed to an all-time high, while the Stoxx Europe 600 index SXXP, -0.66% surged to a six-year high.

With both the December and January data showing surprise declines in inflation, deflation fears are growing more prominent. Since the ECB has an inflation target of just below 2%, economists expect it may be forced to act to start reheating prices.

Barclays last week said it now expects another cut to the main refinancing rate in February or March, by 15 basis points, which would push the key lending rate to a record low of 0.1%. The bank also forecasts a 10 basis-point cut to the deposit rate, which would push it into negative territory for the first time in euro-zone history.

“We see this likely rate cut as the next logical policy step for the ECB, before it would consider engaging in other, politically more controversial, nonstandard measures, possibly during the spring,” the analysts at Barclays said.

Short-term rally

Such a move would likely stir a broader short-term rally in European equities, but in the medium-term, investors should be more selective when trading in a low-inflation environment, analysts said.

Banks could get a boost if the ECB eventually tries some nonstandard measures. The central bank could, for example, launch a Funding-for-Lending program as seen in the U.K. — where the government offers banks cheap funds to lend to households and business — which should increase domestic demand in the euro zone.

“I also think it will be more expensive for the ECB to provide further [direct] support for those banks, so a cheaper way out is to stimulate the economy. It’s easier to help them by making sure there are [fewer bad loans] and that the property market picks up,” McLean said.

In the auto space, McLean pointed to a company such as Fiat SpA IT:F, which has a potential to see improved productivity and a pickup in demand from the euro zone. “The key is to be in some of the perceived riskier assets,” he said.

Read: Fiat, Chrysler: a marriage made in … Holland?

John Ventre, head of multi-manager at Old Mutual Global Investors, agreed that undervalued companies have the most upside potential in this low-inflation environment. Within Europe, he pointed to Italian assets, mainly because stocks there have a lot of catching up to do and therefore are too cheap to be further hit with deflation woes.

“I would wait and see how things pan out in Europe. Meanwhile, you can hide in cheaper assets in the periphery, like the Italy idea. You don’t have to be right on the fundamentals there to get a return,” he said.

More broadly, however, he warned of buying into European equities until the low-inflation problem has been addressed. He suggested going underweight stocks from the region and instead parking money in the euro EURUSD, -0.06% .

U.S. selloff triggers global volatility

“The traditional way of betting on deflation is to buy government bonds, but yields are already so low, there’s not much return left there. If we’ll see serious deflation in Europe, the winner is actually the euro. So one way of playing this is owning the euro,” he said.

A side effect to deflation tends to be currency appreciation, because of the increased purchasing power of the currency.

The deflation trap

A major reason central bankers and economists are worried about deflation is that it pushes up real interest rates, making it more expensive for businesses and households to borrow money and harder to pay back debt. In theory, it also encourages consumers to push back larger purchases into the future, when prices might be lower. This can lead to further deflation and turn into a deflationary trap, with increased joblessness and recession.

One of the best-known and recent examples of this trap is Japan, which had been stuck in a deflation spiral for more than a decade, with low consumer confidence, high unemployment and economic depression. After a major asset bubble in the 1980s, the stock market crashed and the Nikkei 225 index NIK, +0.17% is still 60% off its record high from 1989.

For those reasons, policy makers are extremely aware of deflationary tendencies and generally try their best to fight them.

The latest rate cut in the euro zone in November actually came as a response to declining inflation, but analysts fear rate cuts may not be enough any more. Tougher and more unconventional methods are needed, they say. At the ECB’s Jan. 9 meeting, Draghi said a worsening medium-to-long-term inflation outlook could prompt the central bank ”to take further decisive action”.

“Europe has a serious deflation problem, and asset purchases is the only prescription for this disease,” Ventre from Old Mutual Global Investors said. “But we’re struggling to see a solution to this.”

A quantitative-easing program as seen in the U.S. and the U.K. has been heavily debated several times during the euro-zone debt crisis, with economists and governments discussing whether such a scheme would be within the ECB’s mandate. Draghi has paid lip service to this idea, and that alone has helped European stocks rebound to multiyear highs over the last two years.

Yet bond-buying has been met with resistance by euro-zone heavyweight Germany, on concerns the measure would be used to finance struggling governments.

“I think we’ve learned from the U.K. example that QE can be helpful in supporting the cash value of the economy and preventing the economy drifting into deflation. So it makes sense, from that standpoint, for the ECB to go down that path,” said Stephanie Flanders, chief market strategist for Europe and the U.K. at J.P. Morgan Asset Management.

“There’s no legal bar to the ECB undertaking quantitative easing,” she added. “I have always thought it was a distinct possibility, as long as the central bank was doing it for monetary-policy reasons rather than simply to help out governments.”

More must-reads from MarketWatch:

Roubini says emerging markets pose tail risk to global economy

Ghost of 1929 haunts, as 1997-style crisis hits

10 stocks to buy instead of Apple