Stocks and bonds sending out divergent outlooks on economy

Markets are taking sides when it comes to the direction of the U.S. economy.

In the green corner are stocks. The Standard & Poor’s 500 index is just 0.3% away from a record high reached in March on bets that Donald J. Trump’s administration will push through tax-code changes to spark growth. In the red corner sit U.S. government bonds, where benchmark 10-year Treasury yields have unwound almost half of their post-election increase, suggesting a far more pessimistic view of the economy.

“The increasing divergence between global equity market performance and bond markets has raised questions as to whom is right,” Jefferies Group analysts led by Sean Darby wrote in a note.

Figuring out which market will be on the right side of history is a pressing issue for analysts, investors and traders. If government bonds prove correct, risk appetite may soon vanish; if the optimism displayed by stocks and corporate bonds is vindicated, then interest-rate markets are likely to sell off in coming months, according to strategists.

The issue is gaining added urgency as Mr. Trump nears his 100th day as president with plans to unveil Wednesday a proposal to lower the corporate rate to 15%. Optimism that the new U.S. administration would deliver tax cuts and boost corporate earnings may account for the resilience of bullish equity sentiment, according to strategists at Rabobank International.

“The post-election jump in stocks could at least in part have been due to this mechanistic response rather than an optimistic view of the future,” strategists led by Richard Macguire wrote in a note. A cut in the corporate tax rate would automatically boost earnings per share, justifying an advance in stock prices, they argue.

Still, interest-rate markets are flashing warning signals. Money markets such as the London interbank offered rate and interest rate swaps, for instance, show some alarm over growth prospects next year, according to Bank of America Corp.

“The rates market is pricing in the death of tax reform and dimming 2018 economic prospects,” strategists led by Shyam Rajan wrote in a note to clients.

Technical factors may explain the recent rally in both Treasuries and risk assets, suggesting the divergence in the economic signals sent by the asset classes isn’t as stark as it looks on the surface. For example, hedging by options traders and investors with mortgage books may account for dips in long-dated government bond yields in recent weeks, analysts say.

What’s more, earnings-per-share forecasts for the S&P 500 are rising faster than estimates for first-quarter nominal expansion of the U.S. economy, a factor that has driven the outperformance of stocks over government bonds this year. Analysts at JPMorgan Chase & Co. expect the U.S. grew 4.1% on a non-inflation-adjusted basis.

Meanwhile, the outcome of the first round of voting in the French presidential elections has given rise to a widespread relief rally on the view that geopolitical risk is diminishing.

“It may be that bond markets were more worried about [Ms.] Le Pen, and the Treasury rally reflected flight to quality out of Italian bonds,” says Jim Leaviss, a fund manager at M&G Investments vexed by the inconsistent market signals this month.

What’s more, the outperformance of small capitalization stocks — which tend to be more domestically focused than their large-cap peers — has eased since late February, highlighting that equities, to some extent, are pricing in less enthusiasm over U.S. growth.

But others say that the conflicting messages being sent by stocks and corporate bond spreads, on the one hand, and Treasuries, on the other, can’t continue. JPMorgan analysts led by Eric Beinstein reckon the difference has become “extreme,” and that corporate spreads will likely widen.

At Rabobank, strategists have a starker warning: Treasury valuations suggest “increased certainty that [Mr.] Trump will have trouble in bringing about meaningful changes.”

As bellwethers for economic sentiment, both risk markets and Treasuries can’t be right — highlighting the high stakes for markets as the U.S. administration gears up to unveil its tax proposals.