Sector Rotation in a Rising Inflation Environment: Capitalizing on Core PCE Trends

The U.S. Core PCE Price Index, the Federal Reserve's preferred inflation gauge, has climbed to 2.9% year-over-year in July 2025, marking the highest level in five months. This persistent inflationary backdrop, driven by Trump-era tariffs and supply chain bottlenecks, has created a fertile ground for strategic sector rotation. Investors who align their portfolios with inflation-linked sectors—such as Construction and Engineering—while underweighting inflation-sensitive sectors like Healthcare Services, may unlock superior risk-adjusted returns.

Construction and Engineering: Inflation's Beneficiaries

The construction sector has historically thrived during inflationary periods, and the current environment is no exception. Firms like Caterpillar (CAT) and Bechtel (BHE) have demonstrated robust performance, leveraging their ability to pass rising material costs—steel, cement, and lumber—to clients. Government infrastructure spending, bolstered by federal and state-level initiatives, has further amplified growth prospects. For instance, the 2022 Bipartisan Infrastructure Law allocated $550 billion to roads, bridges, and housing, while state-level bond issuances added $120 billion annually.

Historical data underscores this trend: construction stocks outperformed the S&P 500 by 18% during prior inflationary shocks, including the 1970s stagflation and the 2021–2022 surge. The sector's resilience stems from its cost-pass-through capabilities and access to low-cost financing as the Fed signals potential rate cuts in Q4 2025. For example, the iShares U.S. Construction Producers ETF (ITB) surged 8% in June 2025 following the Core PCE data release, reflecting market confidence in the sector's inflation resilience.

Healthcare Services: A Cautionary Tale

In stark contrast, the healthcare services sector has struggled to adapt to inflationary pressures. Fixed reimbursement rates for Medicare and Medicaid, coupled with resistance from private insurers to premium hikes, have left providers unable to offset rising costs. Labor expenses alone have surged 6.2% year-over-year, while supply chain bottlenecks for medical goods—such as PPE and pharmaceuticals—have further eroded margins.

UnitedHealth (UNH) and Pfizer (PFE) exemplify this underperformance, with shares falling 1.2% and 0.8%, respectively, following the June 2025 Core PCE release. Historical backtests reveal that healthcare services underperform the S&P 500 by an average of 2.8% during 60-day periods after inflationary shocks. Structural inflexibilities, such as rigid reimbursement models and labor cost inflation, make this sector particularly vulnerable in a high-inflation environment.

Strategic Sector Rotation: A Framework for Action

The divergence between construction and healthcare sectors highlights the importance of sector-specific fundamentals in navigating inflation. Investors should consider the following strategies:

1. Overweight Construction/Engineering Firms: Prioritize companies with strong government contract pipelines or exposure to housing demand. Firms like Fluor Corp. and AECOM are well-positioned to capitalize on inflation-linked pricing power and macroeconomic tailwinds.
2. Underweight Healthcare Services: Until reimbursement models and input costs stabilize, reduce exposure to healthcare providers and insurers. Focus on firms with pricing flexibility or those insulated from labor cost pressures.
3. Monitor Key Macroeconomic Signals: The August 2025 GDP report and September FOMC meeting will provide critical insights into inflation's trajectory and the Fed's policy stance.

Conclusion: Navigating the Inflationary Landscape

The current inflationary environment, as reflected in the core PCE data, demands a nuanced approach to sector rotation. While construction and engineering firms benefit from cost-pass-through mechanisms and infrastructure tailwinds, healthcare services face structural headwinds that limit their ability to adapt. By aligning portfolios with inflation-linked sectors and avoiding inflation-sensitive ones, investors can enhance risk-adjusted returns in an uncertain macroeconomic climate.

As the Fed contemplates rate cuts in Q4 2025, the construction sector's access to cheaper financing will likely amplify its outperformance. Conversely, healthcare services must navigate regulatory and cost pressures until structural reforms address their margin vulnerabilities. For now, the data supports a strategic tilt toward construction and away from healthcare—positioning portfolios to thrive in a world where inflation remains a persistent force.