U.S. Manufacturing Contraction and Tariff Uncertainty: Implications for Industrial ETFs and Sector Rotation

The U.S. manufacturing sector is in a prolonged contraction, with the ISM Manufacturing PMI hovering below the 50 expansion threshold for five consecutive months as of July 2025. At 48.00, the index reflects a weakening demand environment, rising input costs, and a labor market that has shed manufacturing jobs at an accelerating pace. Tariff-driven uncertainty, particularly under the Trump administration's protectionist policies, has exacerbated these challenges, creating a landscape of volatility for industrial firms. For investors, this raises critical questions about the future of industrial ETFs like the Industrial Select Sector SPDR (XLI) and the iShares U.S. Industrials ETF (IYJ), which are heavily exposed to manufacturing and trade-sensitive subsectors.

The Dual Pressures: Contraction and Tariffs

The ISM data reveals a sector in distress. Over the past 12 months, the index has fluctuated between mild expansion and contraction, with a 12-month average growth rate of just 1.53%. Employment in manufacturing has fallen sharply, with firms reducing headcounts through layoffs, attrition, and hiring freezes. Meanwhile, tariffs—ranging from 10% to 200% on goods from China, Brazil, and other trade partners—have disrupted supply chains, inflated input prices, and created a climate of uncertainty. For instance, aluminum tariffs of 25–50% and copper tariffs of 50% have directly impacted machinery and construction sectors, while proposed tariffs on aircraft and maritime equipment threaten aerospace and logistics.

Industrial ETFs like XLI and IYJ, which hold significant exposure to these sectors, face dual risks. While XLI has outperformed the S&P 500 in 2025 (up 18.2% year-to-date), this performance is driven by a narrow set of high-flying stocks, such as General Electric (GE) and RTX Corp., rather than broad-based strength. The ETF's top holdings—GE Aerospace, Boeing, and Caterpillar—benefit from defense spending and infrastructure tailwinds but are vulnerable to trade policy shifts. IYJ, similarly, is exposed to tariffs via its holdings in automotive and machinery firms.

Sector Rotation: From Vulnerable to Resilient

Amid these headwinds, certain subsectors within industrials have shown resilience. Aerospace and defense stand out as a defensive play. Companies like RTX Corp. and Boeing have surged 31% and 37%, respectively, in 2025, driven by elevated defense budgets and geopolitical tensions. These firms are less sensitive to tariffs and enjoy stable demand from government contracts. Similarly, data center infrastructure has emerged as a growth engine, with firms like Uber and GE Vernova capitalizing on the AI-driven demand for industrial logistics and energy solutions.

Another resilient area is nonresidential construction and public infrastructure. Federal initiatives such as the $4.9 billion Bridge Investment Program have insulated this subsector from broader economic slowdowns. Firms like Caterpillar and Deere, which supply heavy machinery for infrastructure projects, are benefiting from long-term demand. These industries are also less exposed to tariffs, as domestic projects rely on localized supply chains.

Defensive Alternatives and Strategic Reallocation

For investors seeking to mitigate risk in a contractionary environment, a strategic reallocation within industrial ETFs and beyond is warranted. Here's how:

1. Overweight Resilient Subsectors: Adjust exposure to favor aerospace, defense, and infrastructure-heavy stocks within XLI and IYJ. For example, increasing allocations to GE Aerospace (up 64% YTD) or Caterpillar (a key infrastructure supplier) can hedge against broader sector weakness.

2. Underweight Tariff-Sensitive Sectors: Reduce exposure to automotive, machinery, and transportation firms that are highly vulnerable to trade policy shifts. This includes cutting holdings in companies reliant on imported raw materials, such as aluminum or copper, which face immediate cost pressures.

3. Diversify with Defensive Alternatives: While industrials remain core to a long-term portfolio, consider balancing with sectors less impacted by tariffs and economic cycles. Utilities and consumer staples offer stability, but for those committed to industrials, focusing on energy transition plays—such as nuclear power or renewable infrastructure—can provide growth and resilience.

The Path Forward: Navigating Uncertainty

The U.S. manufacturing sector's contraction is unlikely to reverse soon. Tariff uncertainties, supply chain bottlenecks, and high input costs will continue to weigh on growth. However, industrial ETFs like XLI and IYJ offer a path to navigate this landscape by focusing on subsectors with structural demand and low policy sensitivity. Aerospace and defense, data center infrastructure, and nonresidential construction are not only resilient but also aligned with long-term trends like digitization and infrastructure modernization.

For investors, the key lies in active sector rotation. By tilting portfolios toward these resilient subsectors and avoiding those most exposed to tariffs, it is possible to mitigate downside risks while capturing growth opportunities in a fragmented industrial landscape. The coming months will test the sector's adaptability—but for those who reallocate wisely, the rewards may yet outweigh the risks.