Sector Rotation and Strategic ETF Positioning in a Slowing Economy

As the global economy navigates a prolonged slowdown in late 2025 and early 2026, investors are increasingly turning to sector rotation strategies to mitigate risk and capitalize on relative strength. The Conference Board's Leading Economic Index (LEI) underscores a continued decline in consumer and business confidence, amplifying the need for tactical positioning in resilient sectors. This analysis identifies high-conviction ETF plays in leading sectors-Health Care, Communication Services, and Industrials-while highlighting lagging sectors to avoid, offering a roadmap for strategic allocation in a challenging macroeconomic environment.

Leading Sectors: Resilience and Growth in a Downturn

Health Care has emerged as a standout performer, driven by inelastic demand and innovation in AI-driven diagnostics and drug development. The Health Care Select Sector SPDR ETF (XLV) exemplifies this strength, surging 14.5% year-to-date in Q4 2025 and offering a 1.55% dividend yield. Its portfolio includes industry giants like Johnson & Johnson and UnitedHealth Group, which have demonstrated consistent earnings growth despite broader market volatility.

Communication Services is another outperformer, fueled by AI adoption and surging demand for digital infrastructure. The Communication Services Select Sector SPDR Fund (XLC) has benefited from the performance of mega-cap holdings such as Meta, Alphabet, and Netflix, rising sharply in 2025 as the sector represented 10.5% of the S&P 500. Schwab's Sector Views further validate this trend, rating the sector as Outperform due to its alignment with AI-driven content creation and streaming.

Industrials has also shown surprising resilience, with the Industrial Select Sector SPDR Fund (XLI) gaining 16.5% in 2025. This growth is attributed to infrastructure investment, defense spending, and AI-related demand for machinery and electrical systems as noted by ETF analysis. Companies like General Electric and Caterpillar have capitalized on these tailwinds, reinforcing the sector's upgrade to Outperform by Schwab.

Lagging Sectors: Avoiding Vulnerable Plays

Conversely, sectors tied to discretionary spending and interest rate sensitivity are underperforming. Consumer Discretionary and Real Estate face headwinds from strained household budgets and high borrowing costs, with CLiK Trading Education noting weak earnings and global demand fluctuations as key drags. Similarly, Utilities and Consumer Staples are lagging, as investors flee sectors with limited growth potential in a low-inflation, high-rate environment as observed by CLiK Trading Education. A government shutdown in October 2025 further exacerbated volatility, with Financials and Small Caps underperforming amid regulatory uncertainty.

Strategic ETF Positioning: Balancing Risk and Reward

For investors seeking to hedge against a slowdown, a concentrated allocation to XLV, XLC, and XLI offers exposure to sectors with structural growth drivers. XLV's defensive characteristics and dividend yield make it a cornerstone for income-focused portfolios, while XLC and XLI provide growth potential through AI and infrastructure tailwinds as highlighted in ETF analysis. However, diversification remains critical. Overexposure to lagging sectors like Real Estate or Consumer Discretionary could erode returns, particularly as the Conference Board projects further economic contraction.

Conclusion

In a slowing economy, sector rotation is not merely a defensive tactic but a proactive strategy to align with macroeconomic realities. By prioritizing ETFs in Health Care, Communication Services, and Industrials-while avoiding vulnerable sectors-investors can position portfolios to weather uncertainty and capitalize on emerging opportunities. As Schwab's Sector Views and CLiK Trading Education emphasize, the key lies in leveraging AI-driven trends and structural demand to outperform the broader market.