Navigating Inflation and Tax Reform: Why Small Businesses Are Key to Sector Resilience

The U.S. economy is navigating a delicate balance between moderate inflation and sweeping tax reforms that favor small businesses. With the Federal Reserve's projections indicating inflation will ease to 2% by 2027, and the One Big Beautiful Bill Act (OBBBA) providing critical tax relief, sectors like manufacturing, construction, and retail are positioned to thrive. These industries, which employ nearly half of the U.S. workforce, are leveraging tax incentives and operational agility to maintain pricing power, reduce labor risks, and capitalize on modest economic growth. Investors should consider strategic allocations to these sectors through targeted equities or ETFs.

Manufacturing: Tax Incentives Drive Capital Efficiency

Manufacturing has emerged as a standout sector due to the OBBBA's full expensing of domestic R&D expenditures and enhanced Section 179 deductions. These provisions allow firms to deduct the full cost of equipment purchases in the year of acquisition, easing cash flow pressures and accelerating investment in automation and efficiency.

Key Opportunities:
- Inventory Management: Companies adopting just-in-time systems or predictive analytics can avoid overstocking in an inflationary environment.
- Pricing Power: Firms with advanced automation can reduce unit costs, enabling them to pass through price increases without sacrificing margins.

XLI, which tracks industrial giants like Caterpillar (CAT) and 3M (MMM), has outperformed the broader market in periods of tax-driven investment booms. Smaller manufacturers benefiting from tax reforms could follow suit.

Construction: Infrastructure Gains and Labor Stability

The construction sector, buoyed by the QSBS expansion (which allows up to 100% exclusion of gains on qualifying small business stock), is poised to benefit from infrastructure projects and housing demand. Tax reforms also address labor challenges:

• Labor Quality: Enhanced employer child care credits (Section 45F) reduce turnover risks, as small firms can now pool resources to offer childcare services.
• Capital Flexibility: Full expensing of domestic R&D and bonus depreciation incentivize investments in green technologies or modular construction, which reduce project timelines and costs.

Both ETFs have historically surged during periods of tax reform and infrastructure spending. With the OBBBA's incentives, smaller firms in this sector could see disproportionate gains.

Retail: Pricing Power and Inventory Precision

Retailers, particularly in durable goods and e-commerce, are navigating inflation through dynamic pricing algorithms and data-driven inventory systems. Tax reforms like the SALT deduction increase and permanent QBI deductions provide relief to pass-through entities, enabling reinvestment in technology.

• Pricing Strategy: Retailers like Walmart (WMT) and Home Depot (HD) have shown that incremental price hikes, paired with cost controls, can sustain margins. Smaller competitors leveraging similar strategies could follow.
• Labor Solutions: The childcare credit reduces absenteeism, while automation in warehouses (e.g., robotics) mitigates labor shortages.

XRT's correlation with CPI trends suggests that retail stocks can act as inflation hedges, particularly when companies maintain pricing discipline.

Risks and Considerations

While these sectors show promise, investors must monitor macro risks:
- Interest Rates: The Fed's 2025 rate path (projected to stay at 3.9% until year-end) could curb borrowing costs for small businesses.
- Sector Volatility: Construction and retail are cyclical; allocations should be balanced with defensive holdings.

Investment Strategy: Targeted ETFs and Equities

To capture these opportunities, consider:
1. ETFs:
- XLI (Industrial Sector): For manufacturing and automation leaders.
- ITC (Construction & Engineering): Tracks firms benefiting from infrastructure spending.
- XRT (Consumer Discretionary): Captures retail innovation and pricing power.
2. Equities:
- WELL (Floor & Decor): A home improvement retailer with strong pricing and inventory control.
- HON (Honeywell International): A manufacturing giant investing in automation and energy efficiency.

Conclusion

The confluence of moderate inflation and tax reforms has created a tailwind for small businesses in manufacturing, construction, and retail. By focusing on firms that optimize inventory, stabilize labor costs, and retain pricing power, investors can position themselves to capitalize on a resilient economic landscape. Strategic allocations to sector-specific ETFs or equities with these traits could yield outsized returns in the years ahead.

The author holds no positions in the mentioned stocks or ETFs.