There’s a monumental struggle under way right now that will shape the fate of the US economy and the stock market in 2013. The outcome will determine whether we are headed for continued slow growth or another recession and market collapse.

On one side of the struggle: Consumers are eager to ratchet up spending…housing prices and construction finally are rising…auto sales are increasing…and the Federal Reserve has vowed to keep interest rates extremely low until unemployment levels fall.

On the dark side: The looming “fiscal cliff” of automatic tax increases and across-the-board spending cuts threatens to throw the US economy back into recession…companies have been hesitant to hire or expand in the face of many economic uncertainties…and the debt crisis and recession across much of Europe are hurting the global economy.

Here’s my take on the likely outcome of this struggle and how it will affect you and your investments in 2013…

MUDDLING THROUGH

Next year looks like a tough, muddle-through year. The economy remains in a mostly weak but stubbornly entrenched growth pattern with several pillars of strength. Consumer confidence has been buoyant, even though inflation-adjusted incomes have remained flat and gasoline and food prices have been high. Consumer spending rose at an annual rate of 2% to 2.5% in the third quarter of 2012. While that’s still below the historical average of more than 3%, it’s enough to sustain economic growth because consumer spending accounts for 70% of the gross domestic product (GDP).

Housing has finally moved into a sustainable recovery. And the Federal Reserve has taken its most aggressive stimulus action yet—the third phase of quantitative easing (QE3). It pledged to pump $40 billion a month into the economy by buying up mortgage-backed securities, not just while the economy is weak but for a considerable time after it strengthens and until the unemployment rate is far lower. This will boost confidence, put a bottom under home prices and make households feel wealthier.

Also, some of the uncertainties about 2013 that were holding back Wall Street and corporate America have been reduced simply because the presidential and congressional elections are past, although essentially the same stalemated political lineup remains.

Even though the stock market did very well in the first Obama term, the president will have a tougher time than a Republican president would have had in making progress on the economy and the enormous federal deficit because of the opposition that his policies face from GOP hard-liners in Congress and the mistrust Wall Street has for his tax and environmental policies. But I think both parties will be able to compromise on some major issues. 

THE DARK FORCES

To continue economic growth, we must first get past a variety of challenges, all difficult but manageable. If any of the following risks spins out of control, however, the US could well be in a recession by mid-2013…

Faltering corporate earnings. The fourth quarter of 2012 and first quarter of 2013 will show flat-to-negative revenue and profit growth year-over-year because of lower-than-expected economic growth in the US and China and because much of Europe is in recession. Businesses are stuck in a holding pattern, awaiting the resolution of many of the uncertainties plaguing the economy. But as we work our way through 2013, exports to China and Europe should rise. As those economies improve, corporations will surpass expectations—and I expect earnings to rise.

The eurozone recession. The combined economies of the 17 eurozone countries are likely to decline by 0.2% to 0.8% in 2012. But the pace of that decline is slowing, and confidence among consumers in all-important Germany is rising. By the end of 2013, the eurozone economy will be in recovery, albeit a very anemic one. Attempts to resolve the debt crisis, now in its fourth year, will continue to make slow progress, but the crisis will flare up along the way. Any signs of a real rebound will be an overall positive for the US and global economies and markets.

The Chinese economy. The world’s second-largest economy continued to slow with a 2012 growth rate likely to come in at 7.25% to 7.5%, much less than the average annual rate of 9.9% over the past decade. The silver lining is that we have reached a stable bottom. I expect Beijing to get much more aggressive on monetary and fiscal policy now that the political transition to a new Chinese president and Politburo Standing Committee is over. And I expect GDP growth of 7.5% to 8% in 2013, which will help boost the Asian, European and American economies.

KEY ECONOMIC MEASURES

GDP: I expect the US to resolve many of the uncertainties that the economy and markets face, and GDP will grow by 2.3% in 2013. That’s still weak but significantly better than the disappointing 1.7% growth that 2012 likely will deliver. By 2014, we may be within striking distance of a normal recovery with GDP growth rising to the 3% range.

Unemployment: The optimism of the consumer will continue to be counterbalanced by the reluctance of businesses to spend and hire. Corporations remain in a holding pattern, using a combination of better technology and outsourcing to replace full-time workers. Obamacare costs are pushing many companies to load up on part-timers. Resolution of tax and policy uncertainties will improve the employment situation but not reduce unemployment much. By the end of 2013, I expect unemployment will drop to 7.3%, about one-half a percentage point lower than it is now.

Inflation: Inflation, as measured by the Consumer Price Index, will run near 3% in 2013 but remain moderate enough that the Federal Reserve will maintain its promise of near-zero short-term interest rates without worrying that too much inflation will be triggered.

STOCKS

Investors blissfully focused on booming corporate profits, and especially Apple’s success, for much of 2012. But economic uncertainties and even growing skepticism about Apple’s continued success and about profits registered by other corporations will be harder to ignore in 2013. If we have reasonable resolutions to the dark forces, the stock market will have an OK year. I expect the Dow Jones Industrial Average to rise to the 14,000 level, up 11% from 12,570 on November 14, 2012.

Caution: In the unlikely event that corporate earnings turn negative year-over-year for 2013 and the US economy sinks into a recession, the stock market will be dragged down as well. The worst-case scenario probably sends the Dow down to about 10,500.

Best areas of the stock market now…

Consumer discretionary. Higher household spending will benefit restaurants as well as hospitality and leisure companies. I especially like the automotive sector. Sales of new cars are on pace to hit about 14.5 million for 2012, up sharply from 2009’s 10.4 million.

Housing. Residential construction was the top-performing industry in the stock market this year as of mid-November. Continued low interest rates, increased availability of credit, fewer homes on the market, fewer foreclosures and better household finances will work to keep housing and housing-related stocks rising.

BONDS

Bond prices are very high and yields are at historic lows, creating the danger that when interest rates start to rise, bond prices, especially for long-term bonds, will suffer heavily. Investors should temper expectations for future gains and expect low, single-digit returns in the next year. I am not enthusiastic about the reward potential of corporate bonds or US Treasuries, considering the risks involved in 2013. If the economy surprises on the upside, I expect long-term interest rates to jump. So investors should keep the average maturity of their bond holdings to less than 10 years.

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