Navigating the Labor Market Downturn: Sector Rotation Strategies and the Role of Mortgage REITs

The U.S. labor market is at a crossroads. The Conference Board Employment Trends Index™ (ETI), a leading indicator of employment conditions, has fallen to 106.41 in August 2025—the lowest level since early 2021. This decline, driven by six negative components including shrinking job openings, rising unemployment claims, and weak industrial production, signals a normalization of the post-pandemic labor market. While The Conference Board's Mitchell Barnes attributes this to structural adjustments rather than cyclical weakness, the data paints a cautionary picture for investors.

The Discretionary Sector's Fragility

The Consumer Discretionary sector, which thrives on robust consumer spending, is particularly vulnerable in a weakening labor market. Companies in this sector—ranging from luxury goods to travel and entertainment—rely on discretionary income, which evaporates when unemployment rises or wage growth stagnates. Historical data from the 2020–2022 pandemic downturn shows that as the ETI plummeted, discretionary spending contracted sharply. For example, the leisure and hospitality sector lost 8.2 million jobs in April 2020 alone, a recovery that took 26 months to reverse.

Investors must recognize that even in a partial recovery, the discretionary sector remains fragile. Rising interest rates and inflation have already eroded consumer confidence, with 20% of Americans now reporting that “jobs are hard to get” (up from pre-pandemic levels). This sentiment directly correlates with reduced spending on non-essentials, making the sector a high-risk bet in the current climate.

Mortgage REITs: A Counter-Cyclical Hedge

While the discretionary sector falters, Mortgage REITs (MREITs) offer a compelling counter-cyclical opportunity. These entities, which invest in mortgage-backed securities and adjustable-rate mortgages, historically perform well in environments of rising interest rates—provided the Fed's tightening cycle is nearing its peak.

The 2020–2022 period provides a case study. During the initial pandemic-driven rate cuts, MREITs surged as mortgage demand spiked. However, as the Fed began hiking rates in 2022 to combat inflation, MREITs faced headwinds, with the FTSE Nareit Mortgage REITs Index dropping 26.6% in 2022. Yet, by early 2025, the sector rebounded, posting gains of 5.4% and 6.1% in January and February, respectively. This resilience underscores their potential as a hedge during labor market normalization.

MREITs also offer defensive qualities. With an average dividend yield of 11.4% as of February 2025 (compared to 3.8% for all equity REITs), they provide income stability even amid volatility. Moreover, their performance during recessions has historically outpaced private real estate, averaging a 6.0% cumulative return versus -1.6% for private assets.

Strategic Sector Rotation in Action

A disciplined sector rotation strategy can balance risk and reward in a weakening labor market. Here's how to implement it:

1. Reduce Exposure to Discretionary Sectors: Trim holdings in companies reliant on consumer spending. Focus on defensive sectors like utilities, healthcare, and consumer staples, which are less sensitive to economic cycles.
2. Increase Allocation to MREITs: As the Fed's rate hikes near their peak, MREITs can capitalize on narrowing spreads between mortgage yields and borrowing costs. Prioritize REITs with diversified portfolios and strong balance sheets.
3. Monitor ETI Components: Track indicators like job openings, industrial production, and unemployment claims to time rotations. For example, a rebound in JOLTS job openings (which fell by 176,000 in July 2025) could signal a shift in labor market dynamics.

The Path Forward

The ETI's decline to 106.41 is a warning bell, not a death knell. While the labor market is normalizing, the Federal Reserve's recent rate cuts in September 2025 have already begun to stabilize mortgage rates (30-year fixed rates below 6.5%). This creates a favorable environment for MREITs to rebound, particularly if housing demand rebounds alongside improved inventory levels.

For investors, the key is to remain agile. By rotating out of discretionary sectors and into counter-cyclical MREITs, portfolios can weather the current labor market headwinds while positioning for the next upturn. The ETI, as a leading indicator, will remain a critical tool in navigating this transition.

In a world of shifting economic tides, adaptability is the ultimate asset. The labor market may be cooling, but with the right strategy, investors can turn uncertainty into opportunity.