Inflation's New Divide: Why Construction Soars as Autos Stall

The May 2025 reading of the U.S. Core PCE Price Index—the Federal Reserve's preferred inflation gauge—sent a jarring message: inflation remains stubbornly above target, rising to 2.7% year-over-year. This marks the fastest pace since late 2022 and defies expectations of a steady decline. For investors, the implications are stark: sectors that thrive in inflationary environments are outperforming those reliant on consumer discretionary spending. Nowhere is this divide clearer than between the Construction/Engineering sector, which is booming, and the Automobile sector, which is buckling under tariff-driven pressures.

The Inflation Surprise: Why It Matters

The Core PCE's rise to 2.7% (from 2.6% in April) reflects persistent inflationary pressures, even as overall PCE inflation (including energy and food) remains subdued at 2.3%. This divergence underscores a critical point: service-sector inflation—driven by labor shortages, supply chain bottlenecks, and regulatory costs—is proving more persistent than goods inflation. For sectors like Construction, this is a tailwind; for Automobiles, it's a headwind.

Construction & Engineering: Building Profits in a Hotter Inflation Environment

The Construction sector is benefiting from a trifecta of tailwinds:
1. Infrastructure Spending: The Biden administration's $50 billion grid modernization package, coupled with state-level bond issuances, is fueling demand for transportation, energy, and water projects.
2. Inflation-Linked Contracts: Many construction projects use cost-of-living adjustments or fixed-price contracts that allow firms to pass rising material and labor costs to clients.
3. Corporate CapEx Surge: Companies in energy, utilities, and manufacturing are ramping up spending to modernize facilities and comply with regulations, further boosting demand for engineering services.

Historical precedent supports this outperformance. During the 1970s stagflation, Construction stocks outperformed the S&P 500 by over 20% annually. In the late 2000s inflation spike, they rose 35% versus the S&P 500's 15% gain. Today, the sector's fundamentals are even stronger: Construction unemployment sits at 4.1%, signaling tight labor markets, while infrastructure spending as a share of GDP (2.3%) lags most developed economies, leaving room for growth.

Automobiles: Stalled by Tariffs and Weak Demand

The Automobile sector faces a perfect storm:
- Tariff Headwinds: U.S. tariffs on Chinese imports (including auto parts) average 14.5%, with some reaching 25%. These costs are squeezing margins, as automakers can't fully pass them to consumers due to competitive pricing.
- Consumer Pullback: Real consumer spending grew just 1.2% in Q1 2025, down from 4% in late 2024. Durable goods spending (including autos) fell 3.8% as households prioritize essentials over discretionary purchases.
- Inventory and Pricing Pressures: Used car prices have dipped 2% month-over-month, while new car prices are set to rise as tariff-affected models replace depleted inventories.

The data is bleak: May's seasonally adjusted annual sales rate for new vehicles fell to 15.3 million, down from 15.9 million in 2024. Even industry leaders like Toyota and Ford face headwinds, while Tesla's market share has eroded amid rising competition and price sensitivity.

The Tactical Shift: Rotate to Inflation-Resistant Sectors

Investors should treat this divergence as a call to action:
1. Overweight Construction/Engineering: ETFs like the iShares U.S. Construction Producers ETF (ITB) offer broad exposure to firms like AECOM and Fluor Corp., which benefit from infrastructure spending and inflation-linked contracts.
2. Underweight Consumer Discretionary: Autos, retailers, and consumer staples are vulnerable to margin compression and weak demand. Rotate out of automakers like GM (GM) and Stellantis (STLA) and into defensive sectors.
3. Monitor the Fed's Next Move: While Chair Powell has resisted aggressive rate cuts, a potential easing cycle could further boost Construction, which thrives in low-rate environments.

Conclusion: Inflation's Winners and Losers

The Core PCE surprise has crystallized a clear divide: sectors with inflation-hedging traits are outperforming those reliant on consumer spending. Construction's structural advantages—government spending, contract protections, and corporate CapEx—position it to thrive even if the Fed holds rates. Conversely, the Automobile sector's struggles highlight the risks of operating in a cost-constrained, tariff-ridden environment.

Investors ignoring this divergence risk missing the next leg of the market's rotation. Act now to overweight Construction and underweight Autos—history shows this strategy has worked in past inflationary cycles. The question is: will you follow the data, or get left behind?