Manufacturing pops green, cyclicals may get a boost

What we're watching

A breakout month for manufacturing

U.S. manufacturing recovery has accelerated meaningfully, with the most notable signal coming from the Institute for Supply Management’s purchasing managers index (PMI), a key economic indicator of the sector’s health. A PMI reading above 50 indicates manufacturing is expanding, while a reading below 50 suggests contraction. Activity jumped to 52.6 in January, the highest in more than three years, compared with 47.9 in December.¹ The decisive move marked the first reading above 50 in nearly a year, ending one of the longest contractionary stretches on record.

Among the key underlying metrics in the PMI, new orders posted their largest one-month increase since 2001; output strengthened, and although employment remained in contraction, the pace of decline eased. A slightly higher prices index reinforces the view that inflation pressures remain sticky but not destabilizing. Broader strength among the sub-indexes suggests a more durable return to expansion.

Manufacturing R&D to get a boost from tax policies

Manufacturing contributes approximately 10% to the value-added output of the U.S. economy while services make up approximately 80%. However, manufacturing companies are responsible for 51.8% of all private‑sector research and development (R&D) spending.² The 100% depreciation provision in the One Big Beautiful Bill Act incentivizes manufacturing companies to invest more in R&D, which could translate into higher corporate profitability.

Manufacturing jobs: A tailwind for consumer spending

The delayed January jobs report from the Bureau of Labor Statistics showed the economy added 130,000 jobs, with the unemployment rate ticking lower to 4.3%.³ These numbers were an “upside surprise,” as economists had projected 65,000 jobs and an unemployment rate of 4.4%. While health care and social assistance drove most of the job gains, manufacturing also added some workers, a modest but encouraging signal for the sector.

Most manufacturing firms in the United States are relatively small. In 2022, only 1.75% of these companies had more than 500 employees.⁴ If the upturn in manufacturing activity holds, we could see the sector’s employment stabilize, further providing another tailwind for consumer spending.

Top of mind for investors: Why markets care when PMI breaks 50

The improvement in manufacturing aligns with our ongoing thesis that market breadth is likely to broaden beyond mega-cap stocks. Better PMIs, combined with steady AI-related capital expenditure, are incrementally supportive of cyclical sectors, small caps, and beneficiaries of industrial spending. Although tech earnings have remained resilient, momentum could face headwinds after the rapid run up in key tech sectors. Stronger manufacturing trends provide a counterbalance, in our view. This should support a gradual rotation toward cyclicals as their earnings trajectories align more closely with improving macro conditions.

Chart spotlight: Cyclicals may gain traction relative to defensive sectors

Research by Denise Chisholm, Fidelity’s Director of Quantitative Market Strategy, has posited that one of the most useful ways to analyze PMI is over rolling one-year periods, as opposed to more volatile month-to-month analysis. Framed in this way, PMI tends to fall into four distinct regimes: expansionary and rising, expansionary and falling, contractionary and rising, and contractionary and falling (see Exhibit 1).

A PMI reading of above 50 and rising has historically delivered the strongest industrial production growth and some of the most favorable environments for equity earnings—particularly within industrials and some other cyclicals. Machinery, transportation, and other cyclical industrial subsectors have shown the highest odds of outperformance during this phase.