Services Growth Slows, but Consumer and Real Estate Sectors Offer Bright Spots Amid Cooling Expansion

The Kansas City Fed Services Activity Index dipped to 3 in June 2025, marking a modest slowdown in services sector expansion. While the composite reading signals ongoing growth, the decline from May's 11 highlights uneven momentum across industries. This divergence—between resilient consumer-facing sectors and struggling wholesale and healthcare industries—presents clear opportunities for investors to reallocate capital toward sectors benefiting from persistent demand while avoiding areas facing structural headwinds. Meanwhile, manufacturing's prolonged contraction persists, but flickers of optimism in its future outlook suggest cautious optimism for a potential turnaround.

Services Sector Divergence: Winners and Losers in a Cooling Economy

The June data underscored stark contrasts within the services sector. Restaurant, leisure/hospitality, and real estate activities expanded, buoyed by strong consumer spending and post-pandemic normalization. Restaurants, in particular, saw robust demand, likely reflecting pent-up demand for dining experiences and seasonal summer activity. The leisure/hospitality sector's growth aligns with travel trends, as vacation bookings and tourism rebound. Real estate's resilience, however, remains puzzling given rising mortgage rates—suggesting either a lag in price adjustments or sustained demand in affordable housing markets.

Conversely, wholesale trade and healthcare sectors contracted, pointing to sector-specific challenges. Wholesale's decline may stem from supply chain adjustments or reduced inventory needs, while healthcare's struggles could reflect ongoing cost pressures and reimbursement delays tied to federal budget negotiations.

Manufacturing's Lingering Slump, but Glimmers of Hope

The Tenth District Manufacturing composite index remained in contraction at -2 for the 22nd consecutive month, with declines in metal and transportation equipment production. However, the manufacturing future index rose to 9—a six-month high—hinting at tentative optimism. Key risks persist:
- Trade disruptions: 52% of firms cited tariff-related delays, with some contracts canceled over titanium material costs.
- Labor shortages: Skilled technical roles and production workers remain hard to fill, exacerbating cost pressures.
- Capital spending freezes: 32% of firms paused investments due to economic uncertainty.

Despite these hurdles, nonmetallic mineral and petroleum manufacturing sectors grew, suggesting some industries are adapting to supply chain constraints.

Investment Implications: Prioritize Resilient Sectors, Mitigate Risks

The data argues for a tactical shift toward consumer discretionary (restaurants, leisure) and real estate, while avoiding overexposure to wholesale and healthcare.

1. Consumer Services Exposure:
   The leisure/hospitality and restaurant sectors align with the XLY (Consumer Discretionary Select Sector SPDR Fund), which includes companies like Marriott and Starbucks. Investors should consider sector ETFs or individual stocks with pricing power and strong brand loyalty.
   

2. Real Estate Opportunities:
   While mortgage rates remain elevated, real estate's expansion suggests demand for affordable housing or rental properties. The IYR (iShares U.S. Real Estate ETF) tracks REITs and could benefit from eventual rate stabilization.
   

3. Caution in Wholesale and Healthcare:
   Until supply chain dynamics or reimbursement policies stabilize, investors should avoid overexposure to wholesale distributors or healthcare providers with narrow margin profiles.

4. Manufacturing's Silver Lining:
   While manufacturing's recovery hinges on resolving trade and labor issues, the improving future index suggests investors might begin lightening exposure to defensive sectors like utilities and shifting toward cyclical plays—but only once the future index surpasses 15. Until then, financials (XLF) remain resilient in rising-rate environments, offering a safer haven.

Risks to Monitor

• Tariff Volatility: Escalating trade disputes could further disrupt manufacturing, particularly in industries reliant on imported materials.
• Labor Shortages: Persistent gaps in skilled labor may limit manufacturing's rebound potential.
• Consumer Sentiment: Services growth could weaken if discretionary spending slows amid rising interest rates.

Conclusion: Navigate Sector Divergence with Precision

The Kansas City Fed data paints a nuanced picture: services growth is cooling, but select sectors offer durable opportunities. Investors should capitalize on consumer and real estate resilience while hedging risks through sector diversification. Manufacturing's fragile rebound underscores the need for patience—waiting for clearer signals before rotating into cyclical stocks. In this environment, disciplined sector allocation and risk management will be critical to navigating the economic crosscurrents.