Navigating Sector Shifts: Capital Reallocation in a Slowing Services Economy

The U.S. ISM Non-Manufacturing New Orders Index for July 2025 stood at 50.3, a marginal decline from June's 51.3. While this reading still signals expansion, it underscores a moderation in service-sector demand—a trend amplified by divergent sector performances. For investors, this data highlights a critical inflection point: the need to reallocate capital from growth-dependent industries like construction to interest-rate-sensitive sectors such as Mortgage REITs.

Divergent Sector Dynamics

The July ISM report revealed stark contrasts. Sectors tied to technological and policy-driven growth—such as AI-related data centers, semiconductors, and defense equipment—saw robust new orders. Conversely, construction, real estate, and healthcare reported declines, hampered by high mortgage rates, tariff-driven inflation, and labor shortages. This divergence mirrors broader economic dynamics: while innovation and infrastructure spending buoy certain industries, others face structural headwinds.

Construction, for instance, has been particularly vulnerable. Elevated input costs from tariffs on materials like steel and aluminum, coupled with a 30-year fixed mortgage rate hovering near 6.5% as of August 2025, have stifled residential and commercial activity. The National Association of Home Builders' sentiment index, while showing slight improvement in late 2025, remains below pre-pandemic levels. Meanwhile, Mortgage REITs have adapted strategically, reducing loan books by 18% year-to-date and pivoting toward multifamily and industrial sectors. This shift has insulated them from some of the volatility affecting construction.

Backtest Insights: Mortgage REITs Outperform

A backtest of Mortgage REITs versus the construction sector during the ISM Non-Manufacturing slowdown reveals actionable insights. From January to August 2025, the Mortgage REITs index delivered a 10.0% total return, outperforming the construction sector's muted performance. While construction firms grappled with cost inflation and delayed projects, Mortgage REITs leveraged liquidity improvements and risk management strategies to stabilize yields.

The FTSE Nareit Mortgage REITs Index, for example, maintained a 12.75% dividend yield as of August 2025—far exceeding the S&P 500's 1.09%. This resilience stems from their sensitivity to interest rate movements. As the Federal Reserve began cutting rates in September 2025, Mortgage REITs positioned to benefit from narrowing spreads and increased refinancing activity. In contrast, construction's reliance on long-term financing and physical project execution left it lagging in response to monetary easing.

Strategic Reallocation: A Path Forward

Investors should consider reducing exposure to sectors with high sensitivity to tariffs, inflation, and labor constraints. Construction, real estate, and healthcare—while foundational to the economy—face near-term headwinds. Instead, capital should flow toward sectors with clearer visibility into policy tailwinds and interest rate responsiveness.

Mortgage REITs, particularly those with diversified portfolios in multifamily and industrial real estate, offer a compelling alternative. Their ability to adjust leverage and asset mix in response to rate changes makes them well-suited for a post-rate-hike environment. Additionally, their high dividend yields (often exceeding 10%) provide income stability amid market volatility.

However, caution is warranted. Mortgage REITs remain sensitive to the pace of rate cuts and refinancing demand. A delayed response to lower rates could temper gains, while rising defaults in commercial financing—down 6.4% in August—pose risks. Investors should prioritize REITs with strong balance sheets and conservative leverage ratios.

Conclusion: Balancing Caution and Opportunity

The U.S. services sector's slowdown is not a collapse but a recalibration. By identifying sectors with structural advantages—such as Mortgage REITs—and avoiding those with cyclical vulnerabilities, investors can navigate this transition profitably. The key lies in aligning portfolios with macroeconomic signals: shifting from growth-dependent industries to those poised to benefit from monetary easing and policy-driven demand.

As the Federal Reserve's rate-cut cycle gains momentum, the next few quarters will test the adaptability of both sectors and investors. Those who act decisively now may find themselves well-positioned for a more stable economic horizon.