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NEW YORK, July 5 (Reuters) - Even as record highs this week in the major U.S. stock indexes telegraph confidence on Wall Street, caution abounds in other U.S. markets, where falling bond yields and flailing small-cap stocks indicate investors are torn about where to place bets.
Hints from Federal Reserve policymakers that the central bank will cut interest rates have buoyed both U.S. stocks and Treasuries. The S&P 500, the Dow Jones Industrial Average and Nasdaq have all notched new highs this week, while yields on the benchmark 10-year Treasury note dropped below 2% to their lowest since late 2016.
Rate cuts often occur in response to signs of emerging economic weakness, which is ultimately negative for equities. Yet lower interest rates are considered supportive of stock valuations by stimulating corporate earnings and capital spending as borrowing costs for companies fall. Such a conundrum was evident on Friday as stocks fell in response to stronger-than-expected U.S. payrolls data, which dampened expectations of a Fed rate cut.
The conflicting signals have given a bid to stocks in defensive sectors such as real estate and consumer staples, yet investors say they are hesitant to abandon cyclical plays, in the event of Fed rate cuts and a trade truce between the United States and China.
"Investors have got to be nuanced," said Andrew Milligan, head of global strategy at Aberdeen Standard Investments in Edinburgh, Scotland. "I wouldn't disagree with being pro-cyclical or pro-yield."
It will likely take several months of economic data - along with results from the corporate earnings season later this month - to clarify the picture, investors say. In contrast to Friday's upbeat employment report, data earlier this week showed U.S. manufacturing and service activity in June declined to multi-year lows.
Some are leaning toward an upbeat outlook. The late 2018 swoon in U.S. stocks was an early harbinger of recent softness in economic data, so equity prices have already taken it into account, said Jim Paulsen, chief investment strategist at the Leuthold Group in Minneapolis. In his view, the S&P's new highs reflect investors' anticipation that the data will turn around with the support of easing monetary policy at the world's major central banks and U.S. fiscal stimulus.
"There's not as much downside as people portray," Paulsen said. "Every policy official in the world is trying to push up the markets and the economy, everywhere you look."
Yet the performance in shares of small-cap companies, which tend to be more domestically focused than their large-cap counterparts, belies such optimism. Though it has gained 16.6% for the year, the small-cap Russell 2000 index has underperformed the benchmark S&P 500 index, which has risen 19.5%. Whereas other indexes have marked new records, it remains 9.7% below its August 2018 high.
"Investors are becoming more and more fearful that the economy is in the late cycle, and small caps, rightly or wrongly, are viewed as a play on the U.S. economy," said Lori Calvasina, head of U.S. equity strategy at RBC Capital Markets in New York.
Furthermore, the Federal Reserve Bank of New York currently forecasts a 29.6% chance of a U.S. recession in the next twelve months. The bank's model, based upon the spread between 10-year and three-month Treasury yields, has reliably predicted recessions once it has hit the 30% threshold, said Lisa Shalett, chief investment officer of Morgan Stanley Wealth Management, in a recent note advising a cautious approach toward U.S. equities.
With the muddled market outlook, several market strategists suggest splitting the difference: adding to positions in defensive sectors while looking for opportunities within beaten-up areas of the market, such as small caps.
Such an approach may be especially prudent given the conundrum regarding the U.S. economic outlook, said Quincy Krosby, chief market strategist at Prudential Financial in Newark, New Jersey. Future data, she said, may end up either confirming recession fears or altogether dashing the hopes for interest-rate cuts that have buoyed stocks.
"The market has got into its head the 'weaker is better' mentality," she said. "Will it be able to substitute stronger economic data for a rate cut? There are a number of scenarios under which it can end up consolidating." (Reporting by April Joyner; Editing by Alden Bentley and Susan Thomas)