Declining Labor Share in the U.S. Economy: Sector-Level Implications for Equity Valuations and Capital Allocation

The U.S. economy has witnessed a persistent decline in labor share-the proportion of GDP allocated to wages and benefits-across key industries from 2020 to 2025. This shift, driven by productivity gains, macroeconomic pressures, and sector-specific dynamics, has profound implications for equity valuations and capital allocation strategies. By dissecting sector-level trends, investors can better navigate the evolving landscape of returns and risk.

Sector-Level Labor Share Trends and Productivity Dynamics

The nonfarm business sector exemplifies the duality of labor share trends. In Q3 2025, productivity surged by 4.9%, outpacing a 2.9% rise in hourly compensation, which reduced unit labor costs by 1.9%. This efficiency-driven performance bolstered corporate margins, supporting equity valuations in capital-light industries. Conversely, the manufacturing sector faced a narrower margin squeeze, with productivity rising 3.3% but unit labor costs climbing 1.5%, reflecting structural challenges in cost management.

The technology sector, particularly the "Magnificent Seven" mega-cap firms, has become a linchpin of equity performance. These companies reported a 26% annualized earnings growth rate in 2025, driven by AI-driven revenue streams in cloud computing, semiconductors, and enterprise software. For instance, the Information Technology sector's aggregate revenue hit $178.4 billion in Q3 2025, a 18.6% year-over-year increase. This outperformance underscores how productivity gains in high-tech industries can decouple equity valuations from traditional labor share metrics.

Meanwhile, the Communication Services sector returned 33.6% in 2025, outperforming the S&P 500, as AI and digital media innovations justified elevated valuations. In contrast, sectors like industrials and energy showed mixed results, with industrials benefiting from early-2025 strength while energy lagged due to global supply gluts and low oil prices.

Capital Allocation and Equity Valuation Impacts

The divergence in sector performance has reshaped capital allocation strategies. Investors increasingly favor growth equities in AI-driven industries, with the Communication Services and Information Technology sectors capturing a disproportionate share of market gains. The Russell 1000 Growth Index outperformed its value counterpart by 2.7% in 2025, reflecting a continued tilt toward high-growth, capital-efficient firms.

However, this concentration has raised concerns about stretched valuations. The S&P 500's price-to-earnings (P/E) ratio remains above historical medians, while the equity premium-the return premium for stocks over risk-free bonds- has compressed to below its long-term average. This suggests that investors are accepting lower risk premiums in pursuit of growth, particularly in sectors with demonstrated productivity gains.

Macro-level factors further complicate capital allocation. Tariff policies and inflationary pressures have widened corporate bond spreads, though they remain below historical medians. In response, investors have shifted toward income-generating strategies, such as short-duration TIPS and equity income funds, while also diversifying into non-U.S. markets. The MSCI EM Index returned 34.3% in 2025, fueled by a weaker U.S. dollar and AI-related growth in emerging economies.

Strategic Implications for Investors

The declining labor share in labor-intensive sectors, such as manufacturing, highlights the need for sector-specific capital allocation. For instance, the manufacturing sector's labor productivity grew 1.5% annually from 2020 to 2025, but unit labor costs rose 0.7% in Q1 2025, signaling margin pressures. Investors may need to prioritize automation and AI adoption in such industries to offset rising labor costs.

Conversely, sectors with favorable labor share dynamics-such as Communication Services and Information Technology-offer compelling long-term opportunities. These industries have leveraged AI to drive revenue growth while maintaining disciplined labor cost structures, as evidenced by the 20.9% year-over-year EPS growth in the Information Technology sector.

For a balanced approach, investors should also consider diversifying into non-U.S. markets and alternative assets. Private equity activity, for example, surged to $310 billion in Q3 2025, as firms capitalized on narrowing valuation gaps and improved financing conditions. This trend underscores the potential for capital to flow toward undervalued sectors and geographies.

Conclusion

The interplay between declining labor share and sector-specific productivity gains is redefining equity valuations and capital allocation. While high-growth, capital-efficient industries like technology and communication services dominate returns, traditional sectors face margin pressures that demand strategic reinvention. Investors must navigate these dynamics by prioritizing innovation-driven sectors, diversifying geographically, and remaining agile in response to macroeconomic shifts.