Sector Rotation Strategies in a Cooling Inflation Environment: Bullish Aerospace & Defense, Bearish Building Materials

The U.S. Core CPI report for June 2025 revealed a 0.1% monthly miss compared to consensus expectations, with annual core inflation settling at 2.9%—below the anticipated 3.0%. This divergence underscores a critical inflection point for investors: inflationary pressures are cooling unevenly across sectors, creating asymmetric opportunities and risks. By analyzing the drivers behind the CPI miss and historical sector performance, we identify Aerospace & Defense (A&D) as a bullish play and Building Materials as a sector to avoid—positioning investors to capitalize on this divergence.

The CPI Miss: A Sector-Specific Cooling Trend

The June CPI shortfall was driven by declines in vehicle prices (used cars fell -0.7%, new vehicles -0.3%), while shelter costs—the largest core CPI component—rose 0.2%. This mixed signal highlights a decoupling between durable goods inflation (weakening) and shelter-driven inflation (persistent). For investors, this signals that the Federal Reserve's focus on core CPI stability may lead to softer rate hikes or pauses, favoring sectors insulated from broader inflation risks.

Bullish Case for Aerospace & Defense (A&D)

The A&D sector is uniquely positioned to thrive in this environment. Here's why:

1. Defense Spending Surge:
   Global defense budgets are at record highs, with U.S. allocations rising +4.5% YoY in 2025. Programs like hypersonic missile development and next-gen fighter jets (e.g., F-35) are immune to cyclical demand swings.
   

2. Margin Resilience via Innovation:
   Despite input cost pressures (e.g., titanium prices up +15% since 2023), A&D firms are mitigating margin erosion through AI-driven supply chain optimization and digital twin technology. Raytheon Technologies (RTX) has reduced lead times by 20% using predictive analytics.

3. Fed Policy Tailwinds:
   A cooling CPI environment reduces fears of aggressive rate hikes, easing financing costs for long-cycle defense projects.

Investment Thesis:
Buy Lockheed Martin (LMT) and Raytheon (RTX) for their exposure to high-priority defense programs. Consider Boeing (BA) for its hybrid defense-commercial portfolio, though its commercial segment faces cyclical risks.

Bearish Case for Building Materials

The Building Materials sector faces headwinds as the CPI miss hints at weakening demand for housing construction:

1. Shelter Inflation vs. Demand:
   While shelter costs (e.g., rent) rose 3.8% annually, the broader CPI miss signals easing pressure on discretionary spending like home renovations. Investors should note that used car price declines—a proxy for consumer confidence—suggest caution in housing-related spending.
   

2. Geographic Overexposure:
   Regions like Phoenix and San Diego (where CPI rose +3.19% and +4.05%, respectively) dominate building materials demand. However, these markets face overbuilding risks, with housing starts exceeding population growth.

3. Supply Chain Fragility:
   Building Materials firms remain vulnerable to input cost volatility (e.g., lumber prices) and labor shortages. CRH's Q2 2025 earnings report cited +8% wage inflation as a margin drags.

Investment Thesis:
Avoid CRH (CRH) and Martin Marietta (MLM). Consider shorting these names or hedging with inverse ETFs like SPLV (low-volatility stocks).

Historical Backtest: Why This Rotation Works

Past CPI misses provide a playbook for sector performance:

• 2021 Energy Shock:
  Core CPI remained stable at 2.3%, while All-Items CPI spiked to 6.8% due to energy prices. A&D stocks outperformed by +12% vs. the S&P 500, as defense budgets shielded them from energy volatility.

• 2023 Fed Pause Period:
  A core CPI miss (down to 3.0%) triggered a +18% rally in A&D stocks over six months, while Building Materials underperformed by -9% due to slowing housing starts.

Actionable Strategy for Q3 2025

1. Rotate into A&D:
   Allocate 5-7% of your portfolio to LMT, RTX, and NOC, with a focus on their dividend stability (2.5–3.5% yields) and long-term growth from defense modernization.

2. Reduce Exposure to Building Materials:
   Trim positions in CRH, MLM, and EIX (which has exposure to construction equipment).

3. Monitor Fed Policy:
   If the Fed signals a rate cut by year-end—a possibility if core CPI stays below 3%—A&D valuations could expand further.

Conclusion

The June CPI miss is not just a data point—it's a sector rotation signal. Investors who pivot toward Aerospace & Defense and away from Building Materials will position themselves to profit from divergent inflation trends. As the Fed navigates this cooling environment, sectors insulated from cyclical demand and input volatility will dominate.

Stay disciplined, stay tactical.