Strategic Shifts in a Downturning Manufacturing Sector: Favoring Service-Sector Equities Over Industrial-Linked Industries

The U.S. manufacturing sector is facing a critical juncture. The Dallas Fed Manufacturing Business Index for July 2025 fell to -12.7, signaling a fifth consecutive month of contraction in the region's manufacturing activity. This reading, while marginally improved from -15.3 in May, underscores persistent weakness in industrial production, new orders, and capacity utilization. With no updated data for July 2025 yet released, investors are left to grapple with the implications of a sector that has long been a barometer of broader economic health.

Historically, such contractions have triggered a predictable shift in capital allocation: investors rotate out of industrial-linked industries and into service-sector equities. This pattern, rooted in the cyclical nature of economic downturns, is supported by decades of empirical evidence. During periods of manufacturing decline, sectors like utilities, consumer staples, and even passenger airlines have outperformed industrial counterparts such as machinery or energy producers. The key driver? Service-sector equities tend to exhibit more stable cash flows and less sensitivity to macroeconomic volatility, making them a natural hedge during industrial slumps.

The Case for Service-Sector Equities: Airlines as a Proxy

Passenger airlines, a quintessential service-sector asset, have shown remarkable resilience during past manufacturing contractions. For example, during the 2020 pandemic-induced recession, airlines initially suffered severe losses due to collapsing demand. However, as travel restrictions eased and pent-up demand surged, the sector rebounded sharply. By 2023, the industry's return on invested capital (ROIC) had closed the gap with its weighted average cost of capital (WACC) to the second-smallest deficit since 1996. Passenger traffic reached 94% of 2019 levels, driven by a blend of pent-up demand and strategic cost discipline.

In contrast, industrial-linked industries like food products (often grouped under consumer staples) face a paradox. While food is a necessity, the broader industrial sector—including manufacturing equipment and materials—tends to contract during economic downturns. For instance, during the 2008 financial crisis, industrials and energy sectors saw double-digit declines in earnings, while utilities and healthcare posted positive returns. This dynamic is not lost on investors: a sector rotation strategy favoring high-regime Sharpe ratio (RSR) sectors—such as services—over low-RSR sectors (industrials) generated a robust 14.02% annualized alpha from 1985 to 2014, according to backtested data.

Tactical Allocation Recommendations: Leverage Historical Patterns

Given the Dallas Fed's latest reading and the broader trend of manufacturing weakness, investors should consider rebalancing portfolios toward service-sector equities. Here's how:

1. Underweight Industrial-Linked Sectors: Reduce exposure to industrials, energy, and materials, which are historically pro-cyclical. For example, food processing companies may face margin pressures as supply chains remain fragile, while machinery producers contend with weaker demand for capital goods.

2. Overweight Service-Sector Defensives: Allocate to utilities, healthcare, and passenger airlines. Airlines, in particular, could benefit from a “revenge travel” narrative if consumer confidence stabilizes. The sector's ability to manage costs (e.g., fuel hedging, route optimization) and capitalize on pent-up demand positions it well for a rebound in a post-contractionary environment.

3. Leverage ETFs for Precision: Use sector-specific ETFs to implement tactical shifts. For instance, the iShares U.S. Transportation ETF (IYT) offers exposure to airlines, while the SPDR S&P Homebuilders ETF (XHB) represents a concentrated bet on industrial-linked industries.

Macro Risks and Mitigation

While the case for service-sector equities is compelling, investors must remain mindful of macroeconomic headwinds. Elevated interest rates could strain airline balance sheets, and a potential recession might curb discretionary spending. However, historical patterns suggest that service-sector equities outperform during the early stages of a recovery, making them a forward-looking bet.

For those seeking a balanced approach, a 60/40 split between service-sector equities and high-quality bonds could offer downside protection. Alternatively, a long-short strategy—leveraging the underreaction hypothesis—could capitalize on delayed price adjustments in sectors like utilities or healthcare.

Conclusion

The Dallas Fed's manufacturing data paints a bleak picture for industrial-linked industries, but it also highlights an opportunity. By tilting portfolios toward service-sector equities—particularly those with strong cash flow visibility and low volatility—investors can position themselves to navigate the current downturn and capitalize on the eventual recovery. As the old adage goes, “know your cycle.” In a world of persistent uncertainty, sector rotation remains one of the most reliable tools in an investor's arsenal.