U.S. Labor Market Deterioration and Its Implications for Equity Valuations

The U.S. labor market is showing signs of a structural slowdown, with implications that extend far beyond the headline unemployment rate. The July 2025 employment report, released by the Bureau of Labor Statistics, painted a grim picture: a mere 73,000 jobs added, revised downward figures for May and June, and a labor force participation rate at its lowest since 2022. These numbers are not just statistical anomalies—they signal a broader shift in market fundamentals, one that could redefine equity valuations and investor behavior in the coming months.

Goldman Sachs has sounded the alarm, warning that the U.S. is on a trajectory toward stagflation—a scenario where economic growth stagnates while inflation persists. The firm's analysis ties this risk to two key policy-driven forces: the Trump administration's aggressive tariff policies and the tightening of immigration enforcement. These measures have created a dual squeeze on the labor market. On the supply side, the foreign-born workforce has contracted by 802,000 since April 2024, exacerbating labor shortages in sectors like healthcare and construction. On the demand side, tariffs on Chinese goods have driven up input costs, with core goods prices rising at a 0.53% annualized rate in June 2024. The result is a labor market that is neither expanding nor contracting in a traditional sense but rather stagnating, with inflationary pressures stubbornly embedded.

For equity investors, this environment demands a recalibration of strategies. Historically, stagflation has been a hostile climate for growth stocks, particularly those in the technology sector. The S&P 500's tech-heavy weighting has long been a source of outperformance during low-inflation, high-growth periods. But as the Federal Reserve tightens policy and real interest rates rise, the valuation multiples of high-growth companies—many of which rely on discounted future cash flows—come under pressure. The recent rotation out of tech megacaps into value and international equities underscores this shift.

Defensive sectors, however, are gaining traction. Consumer staples, utilities, and healthcare have historically outperformed during stagflation due to their stable cash flows and inelastic demand. For example, Procter & Gamble (PG) and Johnson & Johnson (JNJ) have seen their earnings hold up despite broader market volatility, as consumers continue to spend on essentials. Utilities, such as Dominion Energy (D), have also benefited from long-term contracts and regulated pricing models that insulate them from inflationary shocks.

Real assets are another key area of focus. Real estate investment trusts (REITs), particularly those in industrial and residential sectors, have shown resilience. The logistics boom driven by e-commerce and supply chain reconfigurations has kept industrial REITs like Prologis (PLD) in demand, while residential REITs such as Equity Residential (EQR) have capitalized on rising rental prices. Gold, too, has reemerged as a hedge, with the SPDR Gold Shares ETF (GLD) seeing inflows as investors seek protection against currency devaluation.

The bond market is also signaling caution. Treasury Inflation-Protected Securities (TIPS) have gained popularity as a hedge against inflation, with their principal adjusting in line with the Consumer Price Index. Meanwhile, short-term Treasuries are being favored for their liquidity and safety, with cash allocations rising to 10–15% in many portfolios. This trend reflects a broader risk-off positioning, as investors prioritize capital preservation over aggressive growth.

For those willing to take a more active approach, sector rotation and tactical asset allocation are critical. Defensive sector ETFs like the Utilities Select Sector SPDR Fund (XLU) and the Health Care Select Sector SPDR Fund (XLV) offer concentrated exposure to resilient industries. Options strategies, such as buying puts on these sectors, can further enhance downside protection. Additionally, global diversification is becoming increasingly important. European and emerging market equities, which have underperformed U.S. stocks in recent years, now offer attractive valuations and less exposure to domestic policy risks.

The path forward is fraught with uncertainty. The Federal Reserve faces a delicate balancing act: cutting rates to stimulate growth while avoiding a resurgence of inflation. Goldman Sachs anticipates three 25-basis-point cuts in late 2025 and early 2026, but the timing and magnitude of these moves will depend on how the labor market evolves. If unemployment rises further or inflation accelerates, the Fed may be forced to delay easing, prolonging the stagflationary environment.

For investors, the key takeaway is clear: adaptability is paramount. A portfolio skewed toward growth and momentum is ill-suited for a world where inflation and weak growth coexist. Instead, a mix of defensive equities, real assets, and inflation-protected bonds offers a more robust framework. As the labor market continues to deteriorate and stagflationary risks rise, those who pivot early will be best positioned to navigate the turbulence ahead.

In the end, the market is already pricing in a shift. The question is not whether stagflation is coming, but how quickly investors can adjust their strategies to survive—and perhaps even thrive—in this new reality.