Navigating the Inflationary Crossroads: Sector Rotation Strategies in the U.S. Services Economy

The U.S. services sector, the backbone of the economy, is at a pivotal juncture. The July 2025 ISM Non-Manufacturing PMI report paints a complex picture: expansion persists, but inflationary pressures are intensifying, driven by tariffs, material costs, and labor shortages. For investors, this creates a unique opportunity to rotate capital toward sectors best positioned to absorb or mitigate these pressures while avoiding those most vulnerable to contraction.

The Inflationary Tightrope

The Prices Paid Index surged to 69.9 in July, the highest since October 2022, signaling acute cost pressures. Tariffs on steel, copper, and other critical inputs have pushed material costs to near-crisis levels. For instance, construction and healthcare sectors face surging expenses for imported equipment and infrastructure materials. Meanwhile, labor shortages—evidenced by the Employment Index at 46.4—have exacerbated wage inflation, compounding the problem.

This dual inflationary dynamic—goods and labor—has created a divergence within the services sector. While 11 industries expanded in July, including Transportation & Warehousing and Finance & Insurance, others like Accommodation & Food Services and Construction are contracting. Investors must discern which sectors can pass on costs to consumers and which are likely to see margins eroded.

Sector Rotation: Winners and Losers

1. Infrastructure and Industrial Services
Construction and logistics firms are grappling with tariffs and material shortages, but they also stand to benefit from long-term tailwinds. The Biden administration's infrastructure spending and private-sector demand for modernization could offset short-term pain. Companies in this space, such as those involved in steel fabrication or project management, may see increased pricing power as clients accept higher costs for essential services.

2. Healthcare and Social Assistance
Healthcare providers are facing rising costs for imported medical equipment and pharmaceuticals. However, the sector's inelastic demand—people will always need healthcare—positions it to absorb cost increases. Investors should focus on firms with strong balance sheets and pricing power, such as UnitedHealth Group (UNH) or Medtronic (MDT), which can navigate inflation while maintaining profitability.

3. Technology and Information Services
The Information sector expanded in July, driven by demand for digital infrastructure and AI-driven solutions. While not directly impacted by tariffs, tech firms benefit from the broader shift to automation and efficiency, which can counteract labor shortages. SaaS (Software as a Service) companies, in particular, offer scalable solutions that reduce operational costs for clients, making them attractive in an inflationary environment.

4. Avoiding the Vulnerable
Industries like Accommodation & Food Services and Professional Services are under pressure. Labor shortages and rising input costs are squeezing margins, and consumer demand for discretionary services may wane as inflation persists. Investors should underweight these sectors or seek defensive plays with strong cash flow, such as essential services within the broader category.

The Fed's Dilemma and Market Implications

The Federal Reserve's decision to hold rates at 4.25%-4.50% reflects its balancing act between inflation and growth. While the services sector's expansion suggests the economy is not in a tailspin, the risk of stagflation—stagnant growth paired with high inflation—looms. For now, the Fed appears to prioritize inflation control, but diverging views among policymakers (e.g., dissenters like Christopher Waller) hint at potential rate cuts later in the year.

Investors should monitor the Fed's next moves closely. A rate cut could provide relief to overleveraged sectors like construction and real estate, while a prolonged tightening cycle may favor cash-generative industries like healthcare and utilities.

Strategic Recommendations

1. Overweight Infrastructure and Healthcare: These sectors combine long-term growth with the ability to pass on costs. Look for firms with strong EBITDA margins and exposure to government or institutional clients.
2. Underweight Labor-Intensive Industries: Avoid sectors with weak employment indices and high wage inflation, such as hospitality and education.
3. Hedge Against Currency Volatility: The U.S. Dollar's strength (DXY index) has been a tailwind for import-dependent sectors. Consider hedging strategies if the Greenback weakens further.
4. Monitor Tariff Developments: Trade policy remains a wildcard. Sectors exposed to tariffs (e.g., construction, manufacturing services) could see volatility if negotiations stall.

Conclusion

The U.S. services sector is navigating a delicate balancing act. While inflationary pressures threaten to erode margins, they also create opportunities for strategic investors. By rotating into sectors with pricing power, inelastic demand, and long-term growth drivers, investors can position their portfolios to thrive in an environment where not all services are created equal. The key is to act decisively, leveraging data like the ISM PMI to identify the next wave of sector leaders.