5 Worst Sector ETFs for Stagflation in H2 2025
- Some of the sectors that benefitted from the 90-day tariff pause may reverse course in the second half.
- Understanding which areas may face the most significant headwinds is crucial.
The economic landscape of 2025 is becoming increasingly complex. June's Consumer Price Index (CPI) reading of 2.7%, a rise from May's 2.4%, coupled with the looming anticipation of the full inflationary impact of President Donald Trump’s "reciprocal tariffs" yet to be fully absorbed by the economy, is fueling concerns about a potential stagflationary environment.
This challenging combination of slow economic growth, persistent inflation and the potential for rising unemployment tends to affect certain sectors of the market disproportionately.
For advisors and investors navigating these uncertain times, understanding which areas may face the most significant headwinds is crucial.
History suggests that consumer discretionary, technology, financials, industrials and real estate are particularly vulnerable during stagflation.
Sector ETFs Under Scrutiny in H2 2025
To better understand the potential implications of stagflation on these specific areas, we can examine the characteristics and potential performance of the largest exchange-traded fund representing each sector. These ETFs offer broad exposure to a diversified basket of companies within their respective industries.
XLY: Consumer Discretionary
The Consumer Discretionary Select Sector SPDR Fund (XLY) invests in companies whose products and services are considered non-essential. In a stagflationary environment where consumer spending power is eroded by inflation and job security is threatened, demand for these discretionary items typically declines sharply, directly impacting the profitability of companies within this ETF. Higher prices due to tariffs on imported goods further exacerbate this pressure.
VGT: Technology and Growth
The Vanguard Information Technology ETF (VGT), representing the growth engine that is the tech sector, can face challenges during stagflation. Higher borrowing rates resulting from the bond market pushing Treasury yields higher can reduce the present value of future earnings, making growth stocks less appealing.
Furthermore, rising input costs due to tariffs on electronic components and a potential slowdown in business and consumer spending on technology products can negatively affect the performance of companies within ETFs like VGT.
XLF: Financials
The Financial Select Sector SPDR Fund (XLF), which tracks a broad range of financial institutions, can be presented with a difficult environment resulting from stagflation. Stagnant economic growth can dampen loan demand, while rising unemployment and inflation increase the risk of loan defaults.
Additionally, if Treasury yields remain high because of inflation and the Federal Reserve lowers rates later in 2025 as expected, lending margins will narrow for regional and national banks that depend on interest income for profitability.
XLI: Industrials
The Industrial Select Sector SPDR Fund (XLI) is highly sensitive to economic cycles and global trade. Tariffs on raw materials and components increase production costs for manufacturers. Additionally, a stagnant economy translates to lower demand for industrial goods, transportation services and infrastructure projects, impacting the revenue and earnings of companies held within this ETF.
VNQ: Real Estate
The Vanguard Real Estate ETF (VNQ) provides exposure to a wide range of real estate investment trusts (REITs). Stagflation can create a challenging environment for real estate. High inflation often leads to higher interest rates, increasing borrowing costs for mortgages and development. Slow economic growth and potential job losses can also lead to higher vacancy rates and slower rent growth, negatively impacting the performance of REITs held within VNQ.
Sector ETFs Navigating Uncertain Waters
Interestingly, some of the aforementioned sector ETFs, such as XLY and VGT, have shown resilience and even outperformed since the initial 90-day tariff pause in April. This may reflect initial market optimism or a lag in the full economic impact of the tariffs being realized. However, the underlying threat of tariff-related inflation and a slowing economy can still exert significant downward pressure on these sectors in the coming months.
In the face of such economic uncertainty and the potential for stagflation, a prudent investment strategy emphasizes diversification across various asset classes and sectors. Maintaining a long-term investment horizon, rather than making short-sighted decisions based on fleeting market trends, is also crucial.
Ultimately, aligning portfolios with individual risk tolerance and financial goals remains the wisest approach as we navigate the complexities of the economic landscape in 2025 and beyond.
