Diverging Sectors in the U.S. Economy: Services Thrive While Manufacturing Contracts

The U.S. economy in late 2025 is marked by a stark divergence between its services and manufacturing sectors. While the services sector continues to expand, driven by resilient demand and export growth, manufacturing faces persistent contraction amid input cost pressures and labor market challenges. This divergence has profound implications for investment strategies in 2026, as capital flows increasingly favor service-oriented equities and inflation-linked assets.

Services Sector: Expansion Amid Structural Challenges

The ISM Services PMI for November 2025 registered 52.6%, signaling continued expansion for the ninth consecutive month. Key subcomponents reinforce this trend: the Business Activity Index expanded at 54.5%, and the New Orders Index remained in growth territory at 52.9%. These figures highlight robust demand, particularly in sectors such as healthcare, communication services, and retail trade, which have outperformed broader markets.

However, the services sector is not without vulnerabilities. The Employment Index contracted for the sixth straight month at 48.9%, reflecting a labor market slowdown exacerbated by government shutdowns and rising input costs. Supplier Deliveries also slowed, with a reading of 54.1%, and the Prices Index remained elevated at 65.4%, underscoring persistent inflationary pressures. Despite these headwinds, the sector's ability to absorb shocks-bolstered by strong consumer spending and export demand-positions it as a key driver of economic resilience.

Manufacturing Sector: Prolonged Contraction and Structural Weakness

In contrast, the ISM Manufacturing PMI for November 2025 fell to 48.2%, marking a ninth consecutive month of contraction. The New Orders Index and Employment Index both declined, while Supplier Deliveries accelerated, indicating tighter input availability but insufficient to offset broader weakness. Price pressures lingered, with the Prices Index at 58.5%, as tariffs and global supply chain disruptions continued to strain margins.

The manufacturing sector's struggles are unevenly distributed. While industries like Computer & Electronic Products and Food, Beverage & Tobacco Products expanded, others-such as Transportation Equipment and Apparel-contracted. This fragmentation reflects a broader shift in global demand, with capital increasingly favoring sectors tied to domestic consumption over capital-intensive manufacturing.

Sector Rotation and Strategic Shifts in Capital Allocation

The divergence between services and manufacturing has catalyzed a notable sector rotation in equities. In November 2025, healthcare and communication services stocks gained 9% and 6%, respectively, as investors sought defensive earnings stability. Conversely, technology stocks-once the year's dominant performers- corrected by 4%, as concerns over stretched valuations and AI-linked funding circularity risks emerged.

Small-cap equities also gained traction, with the Russell 2000 and Russell Microcap indices posting significant gains. This rotation reflects a search for undervalued opportunities in service-oriented and regional businesses, which are better positioned to navigate the current macroeconomic environment.

Inflation-linked assets have similarly attracted attention. Fixed income markets delivered 0.6% returns in November 2025, pushing year-to-date gains to 7.5%. This trend aligns with a broader shift toward assets that hedge against inflation, as the Federal Reserve's 2% target remains elusive.

Strategic Implications for 2026

The 2026 investment landscape must account for this structural divergence. First, investors should overweight service-oriented equities-particularly in healthcare, communication services, and small-cap segments-that benefit from resilient demand and inflationary tailwinds. Second, manufacturing exposure should be selectively allocated to subsectors with strong input cost dynamics, such as Food, Beverage & Tobacco Products. Third, inflation-linked assets, including Treasury Inflation-Protected Securities (TIPS) and real assets, offer a critical hedge against macroeconomic uncertainty.

However, risks remain. Policy shifts, such as changes to tariff regimes or fiscal stimulus, could alter sectoral trajectories. Additionally, a sharper-than-expected slowdown in global demand could test the services sector's resilience. Investors must remain agile, balancing growth opportunities in services with defensive allocations to inflation-linked assets.

Conclusion

The U.S. economy's divergent sectors in 2025 underscore the importance of strategic sector rotation. As services thrive and manufacturing contracts, capital flows are increasingly aligning with sectors that offer both growth and inflation protection. For 2026, a disciplined approach-prioritizing service-oriented equities and inflation-linked assets-will be essential to navigating this complex macroeconomic landscape.