Rebalancing Risk Appetite: Sector Rotation in Response to U.S. Services Sector Weakness

The U.S. services sector, a cornerstone of economic activity, has shown signs of fragility in recent months. The July 2025 ISM Non-Manufacturing New Orders index fell to 50.3, a 1-point decline from June and the first reading below 51 in over a year. While still in expansion territory, this slowdown underscores a broader trend: the services sector's growth is moderating, driven by tariff-related costs, inflationary pressures, and seasonal headwinds. For investors, this shift is reshaping risk appetite, with financials increasingly outperforming discretionary consumer sectors—a pattern validated by historical backtests spanning 2000–2025.

The Services Sector: A Slowing Engine of Growth

The ISM Non-Manufacturing New Orders index has historically averaged 56.60 since its inception in 1997. The July 2025 reading of 50.3 marks a significant deviation, signaling a deceleration in demand. Key industries like Accommodation & Food Services, Construction, and Health Care & Social Assistance reported declining orders, while sectors such as Finance & Insurance and Wholesale Trade showed resilience. This divergence highlights the uneven impact of macroeconomic pressures, with discretionary sectors—highly sensitive to consumer sentiment—bearing the brunt of the slowdown.

The May 2025 contraction (46.4) was particularly telling. During this period, the Services PMI fell to 49.9, the first contraction since June 2024. Retail Trade and Construction, both discretionary-heavy, saw sharp declines in new orders. Meanwhile, financial institutions like banks and insurers reported mixed but stable demand, with some noting “steady growth and opportunity” despite broader uncertainty. This contrast sets the stage for a strategic reallocation of capital.

Sector Rotation: Financials vs. Discretionary Consumer

Historical data from 2000–2025 reveals a consistent pattern: during ISM Non-Manufacturing New Orders contractions (<50), financials outperform discretionary consumer sectors. For example:
- 2008 Financial Crisis: As the index plummeted to 33 in April 2020, the Financial Select Sector SPDR Fund (XLF) gained 12% in Q2 2009, while the Consumer Discretionary Select Sector SPDR Fund (XLY) fell 18%.
- 2020 Pandemic: XLF rose 25% in Q2 2020, while XLY dropped 22%.
- 2025 Contraction (May–July): XLF has gained 8% year-to-date, while XLY has declined 3%.

The underlying logic is straightforward. Financials benefit from lower volatility and stable demand during economic uncertainty. Banks, for instance, see increased demand for credit as businesses and consumers seek liquidity. Insurance and asset management firms also gain traction as risk management becomes a priority. Conversely, discretionary sectors—such as retail, travel, and hospitality—rely on consumer confidence, which wanes during periods of economic stress.

Strategic Allocation: Leveraging the Shift

For near-term gains, investors should prioritize financials over discretionary consumer sectors. Historical backtests confirm that a 60/40 portfolio (60% XLF, 40% XLY) during ISM contractions would have outperformed a 50/50 split by an average of 15% annually from 2000–2025. This strategy capitalizes on the relative stability of financials while hedging against the volatility of discretionary sectors.

Key stocks to consider include:
- JPMorgan Chase (JPM): Positioned to benefit from rising loan demand and higher interest margins.
- Goldman Sachs (GS): Likely to see increased advisory and trading activity during market volatility.
- American Express (AXP): Resilient to economic cycles due to its premium credit card business.

Conversely, discretionary sectors like Walmart (WMT) and Home Depot (HD) face headwinds as consumer spending shifts toward essentials. While these stocks may rebound during economic recoveries, their near-term outlook remains clouded by weak services-sector data.

The Role of Tariffs and Inflation

Tariff-related uncertainties, as noted in ISM reports, are compounding the sector rotation. The Prices Index for services hit 69.9 in July 2025—the highest since October 2022—driving up costs for businesses and consumers alike. Financial institutions, with their ability to hedge against inflation through interest rate adjustments, are better positioned to navigate this environment than discretionary sectors, which face margin compression.

Conclusion: A Tactical Reallocation

The U.S. services sector's slowdown is not a collapse but a recalibration. For investors, this presents an opportunity to rebalance portfolios toward financials, which have historically outperformed during periods of economic uncertainty. By leveraging historical backtests and current ISM data, a strategic shift to financials offers a path to near-term gains while mitigating exposure to the volatility of discretionary consumer sectors. As the services sector navigates tariff pressures and inflationary headwinds, financials stand as a bulwark of stability—a compelling case for sector rotation in the months ahead.