U.S. Services-Sector Stagnation and the Imperative of Sector Rotation in Late-Cycle Investing

The U.S. services sector, long a pillar of economic resilience, has entered a critical juncture. The latest ISM Services PMI data for September 2025 reveals a reading of 50%, the first time since January 2010 that the index has hit the breakeven point between expansion and contraction, according to the ISM report. This marks a sharp reversal from August's 52%, signaling a stall in growth momentum, as Rob Marris notes in his sector-rotation commentary (https://robmarris.net/p/rotate-sectors-as-macro-cycles-shift/). The Business Activity Index, a key gauge of sector health, fell to 49.9%, entering contraction territory for the first time since the pandemic's early days (the ISM report). Meanwhile, the Employment Index continued its downward spiral at 47.2%, remaining in contraction for the fourth consecutive month (the ISM report). These data points underscore a sector grappling with stagnation, even as the New Orders Index clings to expansion at 50.4% (the ISM report).

The Late-Cycle Dilemma: Stagnation, Inflation, and Risk Reallocation

The services sector's underperformance is emblematic of a broader late-cycle economic dynamic. As central banks tighten monetary policy to curb inflation, the cost of capital rises, disproportionately affecting sectors reliant on discretionary spending and labor-intensive operations. The ISM data aligns with broader macroeconomic trends: the Prices Index remains stubbornly high at 69.4%, reflecting persistent inflationary pressures (the ISM report). This is compounded by supply chain bottlenecks, as the Supplier Deliveries Index at 52.6% indicates slower delivery performance (the ISM report).

In such an environment, investors must recalibrate their strategies. Sector rotation-the practice of shifting capital toward sectors best positioned to thrive in a given economic phase-becomes paramount. Late-cycle investing typically favors defensive sectors like healthcare, utilities, and consumer staples, which offer stable cash flows and pricing power, according to a sector rotation guide. Conversely, growth-oriented sectors such as technology and industrials, which thrived during the expansion phase, face headwinds as interest rates rise and earnings momentum wanes, as explained in a Financial Analyst Guide.

The interplay between labor market dynamics and inflation further complicates the picture. Elevated wage growth in services subsectors like leisure and hospitality has a direct, contemporaneous effect on inflation, while education and health services exhibit a lagged impact, as detailed in a Cleveland Fed analysis. This creates a feedback loop: higher wages drive inflation, which in turn pressures central banks to maintain tighter monetary policy, exacerbating the sector's challenges.

Strategic Reallocation: Navigating the New Normal

For investors, the path forward requires a nuanced approach. Defensive sectors, particularly those with pricing power, offer a buffer against inflation. Energy and materials, for instance, benefit from higher commodity prices, while healthcare and utilities provide consistent demand regardless of economic conditions (see the sector rotation guide). ETFs focused on these sectors can facilitate efficient reallocation, allowing investors to scale exposure without overreliance on individual stocks, as Rob Marris suggests.

However, the risks of misalignment are significant. The Employment Index's prolonged contraction-now in contraction for five of the last six months-signals a labor market struggling to adapt to structural shifts (the ISM report). This raises questions about the sustainability of wage-driven inflation and the potential for a sharper correction if demand in services cools further. Investors must also monitor yield curve inversions and consumer confidence metrics, which often precede recessions (see the sector rotation guide).

A visual representation of sector rotation strategies in late-cycle environments could illuminate these dynamics.

Conclusion: Balancing Caution and Opportunity

The U.S. services sector's stagnation is not merely a cyclical blip but a harbinger of deeper structural challenges. As the Federal Reserve grapples with the dual mandate of price stability and maximum employment, investors must adopt a dual strategy: hedging against inflation through defensive allocations while remaining agile to capitalize on potential rebounds in growth sectors. The key lies in aligning portfolio allocations with macroeconomic signals, ensuring resilience in an era of heightened volatility.

The data is clear: the services sector is at a crossroads. For investors, the imperative is to rotate with precision, reallocate with foresight, and remain vigilant in an economy where the lines between growth and contraction are increasingly blurred.