U.S. ISM Non-Manufacturing Employment Contracts More Than Expected: Sector Rotation Opportunities Emerge Amid Services Sector Weakness

The U.S. ISM Non-Manufacturing Employment Index, a critical barometer of labor market health in the services sector, has plunged to 46.5 in August 2025, signaling a contraction for the third consecutive month. This reading, just 0.1 percentage point above July's 46.4, underscores a persistent slowdown in hiring within the services sector, which accounts for nearly 80% of U.S. economic output. The index's failure to cross the 50% threshold—a dividing line between expansion and contraction—highlights a stark disconnect between broader economic activity and employment growth. While the Services PMI overall remains in expansion territory at 52%, the Employment Index's drag reveals a labor market that is increasingly decoupled from business activity.

The Services Sector's Employment Dilemma

The contraction in the ISM Non-Manufacturing Employment Index is not an isolated event but part of a broader trend. The index has been in contraction for five of the last six months, with readings as low as 46.2 in March 2025. This prolonged weakness is driven by soft demand, cautious hiring practices, and the lingering effects of tariffs, which have forced businesses to prioritize cost control over workforce expansion. Respondents to the ISM survey cited challenges in passing cost pressures to customers, leading to reduced hiring and shorter work hours.

The services sector's struggles are further amplified by its role as a bellwether for consumer spending. With employment in industries like retail trade, finance, and education declining, the sector's inability to generate jobs raises concerns about broader economic resilience. For investors, this signals a need to reassess exposure to services-heavy equities and pivot toward sectors demonstrating stronger labor market fundamentals.

Sector Rotation: Non-Services Sectors Shine Amid Weakness

While the services sector falters, non-services industries have shown remarkable resilience. Bureau of Labor Statistics (BLS) data for Q2 2025 reveals that healthcare, transportation and warehousing, and government sectors added significant jobs. For example:
- Healthcare added 51,000 jobs in April and 62,000 in May 2025, driven by aging demographics and rising demand for medical services.
- Transportation and warehousing saw 29,000 jobs added in April, reflecting robust supply chain activity and manufacturing output.
- Government employment, particularly in education, surged by 47,000 jobs in June 2025, as state budgets allocated funds for infrastructure and public services.

Productivity gains in non-services sectors further reinforce their appeal. Manufacturing sector productivity rose 2.5% in Q2 2025, with durable goods manufacturing up 3.2%, driven by efficiency improvements and strong output. The nonfarm business sector, which includes manufacturing and utilities, saw productivity increase by 3.3%, outpacing the long-term average. These gains suggest that non-services industries are adapting to macroeconomic headwinds through innovation and operational efficiency.

Strategic Implications for Investors

The divergence between services and non-services sectors presents a compelling case for sector rotation. Investors should consider overweighting industries with strong employment growth and productivity gains while underweighting services sectors facing structural headwinds. Key opportunities include:

1. Healthcare: With aging populations and rising healthcare costs, this sector is poised for sustained demand. ETFs like XLV (Health Care Select Sector SPDR Fund) and individual stocks such as UnitedHealth Group (UNH) and CVS Health (CVS) offer exposure to a resilient industry.
2. Transportation and Logistics: The 29,000 job additions in Q2 2025 highlight the sector's role in supporting manufacturing and e-commerce. Companies like Union Pacific (UNP) and FedEx (FDX) are well-positioned to benefit from continued supply chain activity.
3. Government and Education: State and local government hiring, particularly in education, reflects long-term fiscal commitments. Contractors like KBR (KBR) and education-focused firms such as Apollo Global (APO) could see sustained demand.

Conversely, services sectors like retail trade, finance, and hospitality—where employment has declined—should be approached with caution. These industries face margin pressures from tariffs and consumer spending shifts, making them vulnerable to further contraction.

Conclusion: Navigating the Labor Market Divergence

The U.S. labor market is undergoing a structural shift, with non-services sectors outperforming the services sector in employment and productivity. While the ISM Non-Manufacturing Employment Index highlights the fragility of the services labor market, BLS data paints a more optimistic picture for non-services industries. For investors, this divergence offers a roadmap for strategic reallocation. By tilting portfolios toward sectors with strong labor market fundamentals and productivity growth, investors can position themselves to capitalize on the next phase of economic expansion.

In a landscape where services employment continues to contract, the path forward lies in identifying and investing in the sectors that are not only weathering the storm but thriving within it.