Sector Divergence and the Path to Profit: Capitalizing on the Services Boom Amid Manufacturing Headwinds

The Kansas City Fed's May 2025 reports reveal a stark divide between the Tenth District's manufacturing and services sectors: one contracting under supply chain and policy pressures, the other expanding despite demand headwinds. This divergence offers a clear roadmap for investors seeking to navigate today's uneven recovery. The message is unambiguous: rotate capital toward service-sector firms with pricing power and away from manufacturing stocks burdened by inventory risks and demand uncertainty.

Manufacturing: A Struggle for Stability

The Tenth District Manufacturing Index registered -3 in May, marking the fifth consecutive month of contraction. While this slight improvement from April's -4 reflects no immediate collapse, the sector faces persistent challenges. Nondurable goods—particularly food and paper—drove the decline, while durable goods showed modest resilience in metals and furniture. However, backlogs of orders have plummeted, and firms report supply shortages and trade policy uncertainty as key constraints.

Price pressures, though easing from earlier peaks, remain uneven. Raw materials and finished goods saw moderated growth, but year-over-year price indexes stayed positive—a sign that inflationary risks linger. Meanwhile, hiring and capital expenditure plans have softened, with 34% of firms planning workforce reductions and 30% cutting capital budgets. This cautious outlook underscores a sector grappling with structural and cyclical headwinds.

Services: A Resilient Engine of Growth

In contrast, the Tenth District Services Sector Composite Index held at 3 in May—a modest expansion despite a dip from April's 10. While tourism and dining led the charge, fueled by post-pandemic demand, business services and consumer services (year-over-year indexes of 12 and 10, respectively) provided steady momentum. Even healthcare and real estate, which stumbled in April, hinted at stabilization.

Crucially, services firms exhibit pricing power absent in manufacturing. Special questions reveal that 37% of services firms are adjusting prices more frequently, and 16% are doing so “much more often”—a stark contrast to manufacturing's passive stance (41% unchanged). This ability to pass rising costs to customers, coupled with pent-up demand in sectors like travel and dining, positions services to outperform.

The Inflation Divide: Why Services Matter

While manufacturing's price pressures are easing, they remain embedded in specific areas like capital expenditures and raw material inventories. Services, however, benefit from a different dynamic: demand-driven pricing. Trade policy uncertainty and supply chain bottlenecks may constrain manufacturing, but services—less reliant on global inputs—can capitalize on domestic demand resilience.

Consider this: 45% of services firms have reduced 2025 demand expectations, yet 19% still anticipate growth. This mixed sentiment suggests an environment where firms with strong balance sheets and pricing discipline will thrive. Meanwhile, manufacturing's inventory overhang and weak backlogs point to lingering risks.

Investment Strategy: Rotate Aggressively

The data compels a decisive shift in portfolios:

1. Overweight Service-Sector Equities: Focus on companies with pricing power in expanding niches like travel, tech-enabled business services, and healthcare (despite its recent softness). Look for firms with low debt and exposure to recurring revenue streams.
2. Underweight Manufacturing-Exposed Stocks: Avoid industries like automotive, electronics, and durable goods, where inventory risks and trade friction loom large.
3. Monitor Policy and Trade Signals: Geopolitical developments could either ease supply chains or worsen costs—staying agile is critical.

Conclusion: Act Now, or Risk Falling Behind

The Tenth District's economic bifurcation is no flash in the pan. Services are the growth engine of this cycle, while manufacturing's recovery remains fragile. Investors who fail to rotate capital into service-sector equities risk missing out on a multi-quarter trend. Conversely, clinging to manufacturing stocks—particularly those with high inventory and debt—exposes portfolios to undue risk.

The message is clear: rotate boldly. The services boom is here.

Note: The views expressed are based on the Kansas City Fed's May 2025 data and do not constitute personalized financial advice. Always consult a qualified advisor.