* Chips tumble on China trade worries

* Dow on course to extend string of all-time closing highs

* Russell 2000 set to snap five-day winning streak

* Indexes: Dow up 0.52%, S&P down 1.28%, Nasdaq down 2.56%

July 17 (Reuters) - The S&P 500 and the Nasdaq fell on Wednesday as plunging microchip shares, in the face of potential escalation of U.S. trade conflicts with China, exacerbated the ongoing rotation out of megacap tech-related stocks.

A report that the Biden administration is considering severe trade restrictions against China sent microchip stocks tumbling 5.8%, marking the Philadelphia SE Semiconductor index's biggest one-day drop since October 2022.

A pullback in the "Magnificent 7" group of momentum stocks, led by Nvidia Corp, Apple Inc and Microsoft Corp, dragged the Nasdaq more than 2% lower, while the benchmark S&P 500 slid more than 1%.

The Dow Jones Industrial Average, which has until recent days underperformed the other two indexes this year, held onto a modest gain and was on course to log its third straight record closing high.

The blue-chip average got a boost from Johnson & Johnson , UnitedHealth Group and, in defiance of the swooning chip sector, Intel Corp.

The smallcap Russell 2000 which has surged 11.5% in the previous five sessions, snapped its longest winning streak in over four years amid renewed interest in more undervalued stocks and sectors within the equities market.

Signaling growing investor anxiety, the CBOE Market Volatility index briefly hit its highest level in six weeks.

"Investors are grappling with whether the bloom has come off the semis, the tech, the megacaps and the Magnificent Sevens," said Chuck Carlson, CEO at Horizon Investment Services in Hammond, Indiana. "We’ve got to get through this earnings season to see whether this rotation is going to hold."

Here is a look at the extent to which megacap momentum stocks and chips have outperformed the broader market this year:

On the economic front, housing starts and building permits surprised to the upside, as strength in multiple-unit projects offsets a dip in single-family homebuilding.

In a separate report, industrial output rose at double the expected rate in June.

The data fell in lock-step with recent reports suggesting that despite signs of softening, U.S. economic resiliency will help the Federal Reserve bring inflation down to its 2% target without tipping the economy into contraction.

On Wednesday, the Federal Reserve released its Beige Book, which showed U.S. economic activity expanded at a modest pace from late May through early July, but reported signs the jobs market continues to soften.

"The narrative has shifted a little bit," Carlson added. "The economy looks like (it is) on a course for soft landing, and thus let's buy the economically sensitive stocks."

Financial markets have priced in a 93.5% probability that the Fed will begin cutting rates in September, according to CME's FedWatch tool.

But monetary policy makers, while acknowledging the central bank is getting closer to cutting rates, many would prefer to see more data confirming that inflation is on a sustainable downward path.

Second-quarter earnings season is gathering steam, with Johnson & Johnson posting better-than-expected profit and revenue driven by strong drug sales. Its shares advanced 3.8%.

United Airlines Holdings is due to report after the closing bell.

As of 2:19 p.m. ET, the Dow Jones Industrial Average rose 213.93 points, or 0.52%, to 41,168.41, the S&P 500 lost 72.37 points, or 1.28%, to 5,594.83 and the Nasdaq Composite dropped 473.24 points, or 2.56%, to 18,036.10.

Among the 11 major sectors of the S&P 500, technology and communication services were down the most, with consumer staples showing the largest percentage gain on the day.

Declining issues outnumbered advancing ones on the NYSE by a 1.47-to-1 ratio; on Nasdaq, a 1.76-to-1 ratio favored decliners.

The S&P 500 posted 81 new 52-week highs and no new lows; the Nasdaq Composite recorded 233 new highs and 33 new lows.

(Reporting by Stephen Culp; Additional reporting by Lisa Mattackal, Ankika Biswas and Medha Singh in Bengaluru; Editing by Rod Nickel)