Capital Markets Outperform as Distributors Struggle: A Sector Rotation Playbook for 2025

The U.S. Philadelphia Federal Reserve's August 2025 Manufacturing Business Outlook Survey revealed a striking paradox: while current manufacturing activity remains weak, the , its highest level since January 2025. This surge suggests that manufacturers are betting on a rebound in demand, despite near-term headwinds. Yet, this optimism contrasts sharply with the underperformance of the distributor sector, . The divergence between capital markets and distributors highlights a critical sector rotation dynamic that investors must navigate in 2025.

The Philly Fed CAPEX Index: A Canary in the Coal Mine

The 's CAPEX index, derived from a survey of regional manufacturers, reflects expectations for capital spending over the next six months. . Firms are preparing for a post-recessionary industrial recovery, with future general activity, new orders, and shipments all hitting multi-month highs. This optimism is not unfounded: the corporate restocking cycle remains robust, and AI-driven productivity investments are accelerating.

However, the current weakness in manufacturing activity—reflected in the broader ISM PMI and weak new orders—creates a tension between near-term pain and long-term gain. For investors, this duality underscores the importance of timing: capital markets, which thrive on forward-looking optimism, are outperforming, while distributors, reliant on immediate demand, are lagging.

Distributors: A Tale of Two Sectors

The distributor sector's performance in 2025 has been a study in contrasts. Larger distributors with market capitalizations exceeding $6.5 billion—many of which are S&P 500 constituents—have outperformed, . These firms benefit from pricing power, supplier leverage, and exposure to resilient end-markets like MRO (maintenance, repair, and operations). For example, Ferguson Enterprises Inc. , driven by demand for AI infrastructure and data center equipment.

Smaller distributors, however, have struggled. , tariffs, and housing market slowdowns. Companies like GMS Inc. . Such swings highlight the sector's exposure to M&A speculation and macroeconomic fragility.

Capital Markets: Riding the Resilience Wave

The capital markets sector, broadly aligned with the Financials index, has maintained a “Marketperform” rating from Schwab, suggesting it will mirror the S&P 500's trajectory. This stability is underpinned by the Federal Reserve's tightening cycle and the sector's exposure to interest rate dynamics. However, the broader economic context—namely, the anticipated end of the manufacturing recession—positions capital markets to outperform in the long term.

. GDP in 2025, driven by reduced election-year uncertainty and a shift toward value stocks. This trend favors capital markets firms that facilitate industrial investment, such as those providing AI-driven tools, automation solutions, and infrastructure financing.

Sector Rotation: From Distributors to Capital Markets

The interplay between weak near-term demand and strong future expectations is fueling a rotation from distributors to capital markets. Here's why:
1. Policy Tailwinds: Onshoring initiatives (e.g., Made in America) and AI investments are boosting CAPEX, which benefits capital markets players.
2. Valuation Gaps: Smaller distributors trade at depressed valuations, while larger ones face margin pressures. Capital markets firms, with their exposure to long-term industrial trends, offer more consistent returns.
3. Earnings Diversification: Distributors are tied to cyclical sectors like housing and consumer goods, which face headwinds. Capital markets firms, however, benefit from a broader range of industrial and tech-driven growth.

Investment Implications

For investors, the key is to balance exposure to both sectors while tilting toward capital markets. Here's a strategic approach:
- Short-Term: Overweight MRO-focused distributors (e.g., Fastenal Co. (FAS), W.W. Grainger (GGP)) due to their resilience and AI-driven demand.
- Long-Term: Allocate to capital markets firms that enable CAPEX growth, such as Goldman Sachs (GS) and Morgan Stanley (MS), which stand to benefit from the industrial recovery.
- Hedge: Use futures or options to protect against a potential slowdown in distributor stocks, particularly in smaller-cap names.

Conclusion: Navigating the Divergence

The U.S. economy is at a crossroads: while current manufacturing weakness persists, the surge in CAPEX expectations signals a pivot toward long-term growth. Distributors, especially smaller ones, remain vulnerable to macroeconomic shocks, while capital markets firms are positioned to capitalize on the industrial recovery. Investors who recognize this sector rotation—shifting from underperforming distributors to outperforming capital markets—will be well-placed to navigate the volatility of 2025 and beyond.

As the Philly Fed's CAPEX index climbs, so too does the case for a strategic reallocation. The future belongs to those who invest in the tools of tomorrow, not the inventory of today.