Navigating Sector Divergence in the U.S. Services Sector: Strategic Asset Allocation in a Fragmented Recovery

The U.S. services sector remains a cornerstone of economic resilience, but the latest ISM Non-Manufacturing New Orders data for July 2025 reveals a nuanced story of divergence. While the index edged down to 50.3—a 1-point drop from June's 51.3—it still signals expansion for the 29th month in 31. Yet, the underlying trends are far from uniform. Investors must now dissect sector-specific dynamics to allocate capital effectively in a landscape where artificial intelligence (AI) and grid modernization are outpacing traditional industries like construction and hospitality.

Sector Divergence: Winners and Losers in the Services Sector

The July report underscores a stark split between industries. Seven sectors, including Wholesale Trade, Transportation & Warehousing, and Finance & Insurance, reported rising new orders, driven by AI-related data center demand, semiconductor policy tailwinds, and infrastructure upgrades. Conversely, seven industries—Accommodation & Food Services, Construction, and Health Care & Social Assistance—saw declines, reflecting weaker consumer spending, regulatory headwinds, and supply chain bottlenecks.

This divergence is not merely cyclical but structural. For instance, the Utilities sector is surging due to grid modernization projects, while Arts, Entertainment & Recreation struggles with post-pandemic normalization and shifting consumer preferences. Investors who fail to account for these contrasts risk overexposure to lagging sectors.

Strategic Asset Allocation: Leaning into Momentum

The data suggests a clear playbook for investors: overweight sectors with tailwinds and underweight those facing headwinds.

1. AI and Semiconductor-Linked Sectors:
   The surge in demand for AI-driven data centers and semiconductors is a structural trend. Companies like NVIDIA and ASML (a key supplier for chipmakers) are benefiting from both private-sector and government-led investments. Investors should consider ETFs like XLK (Technology Select Sector) or individual stocks in AI infrastructure.

2. Grid Modernization and Energy Transition:
   Utilities and energy infrastructure firms are gaining traction as policymakers prioritize decarbonization. The XLU (Utilities Select Sector SPDR Fund) or individual players like NextEra Energy (NEE) could offer long-term growth.

3. Defensive Plays in Resilient Sectors:
   Public Administration and Management of Companies & Support Services remain stable, offering defensive characteristics in a volatile environment. These sectors could serve as ballast in a diversified portfolio.

Conversely, sectors like Construction and Accommodation & Food Services face near-term challenges. While some recovery is likely, investors should avoid overcommitting to these areas until demand stabilizes.

Hedging Against Trade and Tariff Risks

The ISM report also highlights growing concerns about tariff-related uncertainties and their impact on global trade. The New Export Orders Index contracted to 47.9 in July, while the Imports Index fell to 45.9. These figures signal potential headwinds for export-dependent sectors like Wholesale Trade and Transportation & Warehousing.

Investors should hedge against these risks by:
- Diversifying geographic exposure to reduce reliance on U.S.-centric trade.
- Overweighting domestic demand-driven sectors (e.g., Finance & Insurance, Public Administration) that are less sensitive to global trade shifts.
- Monitoring the U.S.-China trade dialogue for policy catalysts that could either alleviate or exacerbate tensions.

The Road Ahead: A Call for Dynamic Rebalancing

The U.S. services sector is no longer a monolith. While the ISM New Orders Index remains in expansion territory, the divergent performance of industries demands a dynamic, sector-rotation strategy. Investors who rigidly hold broad-based services ETFs (e.g., XLF, XLV) may miss out on the high-growth pockets driving the economy.

Moreover, the Services PMI® averaging 52.3 over the past 12 months suggests that the sector's expansion is far from over. However, the moderation in July's reading (50.3) signals a need for caution. A proactive approach—rotating into AI-driven and energy transition sectors while trimming exposure to lagging industries—could position portfolios to capitalize on the next phase of the recovery.

Final Thoughts

The U.S. services sector is navigating a complex landscape of growth and headwinds. For investors, the key lies in granular sector analysis and strategic reallocation. By aligning portfolios with the winners—AI, semiconductors, and grid modernization—while hedging against trade risks, investors can harness the momentum of a fragmented recovery. As always, vigilance and adaptability will be the hallmarks of success in this evolving environment.