Sector Rotation in a High-Inflation Era: Construction Outperforms as Food Products Lag

The U.S. Core CPI report for July 2025 has sent shockwaves through financial markets, surpassing forecasts with a 3.1% year-on-year increase. This surge, driven by persistent supply chain bottlenecks and wage inflation, has reignited debates about the resilience of different sectors in a high-inflation environment. Historically, investors who reallocated capital toward inflation-resistant industries during similar episodes have reaped outsized rewards. Today, the construction and engineering sector emerges as a compelling opportunity, while the food products sector faces mounting headwinds.

Construction/Engineering: A Bastion of Resilience

The construction and engineering sector has consistently outperformed the S&P 500 during inflationary periods, a trend rooted in structural advantages. From the stagflation of the 1970s to the 2025 Core PCE surge, construction firms have leveraged inflation-linked contracts, long-term project horizons, and government-backed infrastructure spending to shield margins. For instance, during the 1970s, construction stocks outperformed the S&P 500 by 20% annually, while the 2008 inflation spike saw the construction ETF (ITB) gain 35% versus 15% for the broader index.

The current environment amplifies these dynamics. The $550 billion Bipartisan Infrastructure Law and $50 billion grid modernization plan have created a pipeline of projects insulated from short-term economic volatility. Over 60% of infrastructure contracts now include cost-of-living adjustments, ensuring that firms like AECOM (ACM) and Fluor Corp. (FLR) maintain profitability even as input costs rise. This structural tailwind positions construction/engineering as a defensive play in a rising inflation world.

Food Products: A Vulnerable Sector

In stark contrast, the food products sector has historically underperformed during inflationary cycles. The sector's reliance on discretionary consumer spending makes it acutely sensitive to demand shifts. During the 1980s transition from manufacturing to services, food processing lagged in automation adoption, leading to productivity declines. In 2022, retail trade productivity fell by 0.4%, with food and beverage stores among the worst performers.

Today, food products firms face a perfect storm: labor shortages, supply chain disruptions, and rising unit labor costs. For example, the food products ETF (XLY) fell 3% in June 2025 as Core PCE surged 2.7%, reflecting investor concerns over margin compression. While consolidation and AI-driven inventory management may offer incremental gains, these solutions cannot offset the sector's inherent vulnerabilities.

Strategic Asset Allocation in a New Inflationary Regime

The Federal Reserve's 5.25% policy rate in 2025 has created a stark divergence in sector valuations. Construction firms, with their fixed-price agreements and long-term project timelines, remain insulated from interest rate hikes. Conversely, food products companies—dependent on consumer confidence and short-term demand—face eroding margins as borrowing costs rise.

Investors should consider a sector rotation strategy that overweights construction/engineering and underweights food products. Historical data shows a 15–20% performance gap during labor market transitions, a trend likely to persist as inflationary pressures linger. For tactical exposure, ETFs like ITB or individual stocks with strong government contract pipelines (e.g., ACM, FLR) offer compelling entry points. Meanwhile, reducing exposure to XLY or its constituents can mitigate downside risk in a high-inflation environment.

Conclusion: Navigating the Inflationary Landscape

As the U.S. economy grapples with persistent inflation, sector-specific dynamics will play a pivotal role in portfolio performance. Construction and engineering firms, bolstered by structural advantages and policy tailwinds, are poised to outperform. Conversely, the food products sector's challenges underscore the need for caution. By aligning allocations with these sector rotations, investors can capitalize on inflationary trends while safeguarding against volatility. In an era of acute economic uncertainty, strategic asset allocation is no longer optional—it is imperative.