Despite some strong headwinds, the U.S. economic recovery should continue at a modest pace in 2013. Early in the year, however, sluggishness is likely as consumers adjust to increased payroll tax rates and the corporate sector absorbs new healthcare and banking regulations. Continued economic uncertainty arising from the debate over taxing, spending, deficits, and debt could also act as a drag on growth.

But several factors point to an economy that is likely to keep chugging along: a resurgence in China and other emerging markets, continued recovery in housing, an ongoing domestic energy boom, and strength in manufacturing. Global growth could benefit from an upswing in economic activity in Japan as a result of policy stimulus and currency devaluation. One possible risk is commodity prices. If robust growth in emerging markets pushes up prices for energy and food, U.S. consumers may feel the pinch and decide to pull back.

A flare-up in the European debt crisis also presents a risk, but credit markets believe that continued but slow progress appears more likely. Relative to German bonds, the yield spreads on the debt of Greece and the other struggling countries have come down. Elections in Italy and Germany could derail reform efforts, but for now, voters on balance appear to be accepting the need for change.

Addressing these and other topics are Lord Abbett Partners Milton Ezrati, Senior Economist and Market Strategist; Zane Brown, Fixed Income Strategist; and David Linsen, Director of Domestic Equity Research.

Q: Some prognosticators have predicted a U.S. recession in 2013, and there are some strong headwinds confronting the economy. Should investors worry about a recession this year?

Zane Brown: Growth is likely to be weakest in the first quarter, partly as a result of the rise in payroll taxes, which will affect 77% of the work force, but recession seems unlikely. We expect growth to improve as the year goes on, as consumers adjust to the higher payroll tax and as we put the budget deliberations in Washington behind us. In addition, we've seen great improvement in housing and a large pent-up demand for autos. In addition, job growth is chugging along at 150,000-160,000 a month, and competitiveness in manufacturing has improved, due in part to lower energy costs arising from the domestic oil and gas boom. But growth overseas has been soft, so exports have been weak.

Milton Ezrati: The household sector has improved its balance sheet, although it's still not in great shape. There is a bias toward slow growth, but I don't believe the higher payroll taxes and the other headwinds will be enough to create a recession. I would also point out that China's economic growth is coming in above expectations, at least according to official data from the Chinese government.

David Linsen: China appears to have stabilized and reaccelerated. In addition to the improved Chinese macroeconomic data, prices for commodities, such as oil and iron ore, and for chemicals, such as polyethylene, have firmed, further suggesting a reacceleration of growth.

Ezrati: Global growth should also benefit from the policies of Japan's new prime minister, Shinzo Abe. The plan to devalue the yen is likely to boost the economy, at least over the next 12–18 months. I don't think it will last, but it will provide a short-term boost.

Linsen: In the U.S. market, big-ticket purchases are strengthening. In addition to a recovering housing market, auto sales also appear strong. Our auto analyst, Chris Wiggins, expects light vehicle sales in the U.S. auto market to total 15.2 million units in 2013, a 7% increase from 2012. Overseas, it's more mixed; he forecasts light vehicle sales to decline by 3% in Europe and increase by 7% in China.

Brown: Regarding China, it was only six months ago that people feared a hard landing. Now, not only is China likely to grow by 7-7.5% but also many people think it could grow by 8-8.5%. China has also upped its targets for loan growth, from seven to eight trillion yuan to nine trillion yuan.¹ When the government sets a target like that, banks are happy to respond.

Demand for loans is coming from a stimulus program that is related to infrastructure aimed at urban areas. This should allow for more migration to these areas from the countryside. The increase in loan targets supports the case that China's economic growth might exceed expectations.

China is also opening up its financial markets, allowing more investment from overseas, and allowing Chinese to invest outside the country.

Ezrati: To add to what Zane said about lending, China has also reversed all the restraints imposed in 2011 when inflation was a concern. So the central bank has brought down interest rates and reduced bank reserve requirements, and the banks are much more liquid than they were.

The infrastructure spending and the opening up of the financial sector suggest that China is reorienting itself toward development of its internal markets. This should create opportunities for the world to sell into that market.

Brown: There is still a risk that growth will be slow in the first quarter or maybe the first half in the United States and especially in Europe. That probably won't change until the second half of the year.

Linsen: Possibly offsetting a second-half acceleration is the negative effect that higher commodities prices could have on the U.S. consumer. In recent years, strong growth in China and emerging markets has put upward pressure on commodity prices, which resulted in a headwind for the U.S. consumer. So, if we see a couple of quarters of better growth in emerging markets, and prices for oil and other commodities rise as a result, that could negatively impact the U.S. consumer again. That could put at risk the expectations for second-half growth.

Brown: Another risk is the sovereign debt crisis in Europe. Italy will hold an election on February 24–25, and if former prime minister Silvio Berlusconi captures a large share of the vote, that could undermine some of the progress achieved under current prime minister Mario Monti. Success by Berlusconi could shape opinion in Europe about how much more austerity they want to tolerate. If the progress achieved in Italy is unwound even a little, we might see that occur in Greece and Spain as well because there is still a lot of dissent in those nations regarding austerity measures, especially in Greece.

Ezrati: I agree the Italian elections are very important. The polls currently show that the voters appear likely to support the austerity measures. Amazingly, the ex-communist head of the left-leaning Democratic Party, Pier Luigi Bersani, has embraced the austerity measures, the labor market reforms, and all that Prime Minister Monti put in place. And Bersani is currently leading in the polls.

If Berlusconi wins, he would reject the austerity measures, the deal that Italy made with the European Union, and all the internal reforms. Then Italy would be back where it started. This is important, because then Greece, Portugal, and Spain could follow suit.

But the market could force Italy's hand. That is, if Italy rejects the austerity program, then all the assistance from the International Monetary Fund [IMF] and the European Central Bank [ECB] will be withdrawn, and the spreads on Italian debt will go through the roof. That would put Italy at the brink of bankruptcy almost immediately.

And if the market believes that Spain, Greece, and Portugal could follow Italy's example, the market could then do the same to those nations’ debt. So, the market could force them to stick with the austerity plan.

Q: The U.S. House of Representatives recently passed an extension of the debt ceiling, raising the possibility of another showdown later this spring. What sort of impact could repeated, short-term extensions like this have on the U.S. economy and the market?

Brown: If nothing is done at the end of this three-month extension, it is likely to be a drag on the economy. But Congress will have to address the budget sooner than that because the sequestration deadline is coming up at the end of February.

The market appears to be pricing in the likelihood that something more permanent will be done at the end of this three-month extension. I don't think the market is expecting another short-term extension in three months. If that happens, it might not be well-received by the stock market, and it would raise the likelihood of a credit rating downgrade by both Fitch and Moody's. [Standard & Poor's has already issued a downgrade.] They have suggested that if Congress can't address the combined issues of debt ceiling and budget deficits, then they will downgrade the U.S. credit rating.

Brown: Progress on the deficit is likely to come only through small steps. Essentially, that is what has happened in Europe. Officials there also took a lot of little baby steps that made it appear as if nothing significant was being accomplished. But looking back over the past year, they actually made some progress. They empowered the ECB, and ECB president Mario Draghi did resolve to "do whatever it takes" to save the euro. And here we are a year later, and the crisis appears to be a lot more contained.

Ezrati: There is a possibility that sequestration [in the United States] will be resolved in another way. If House Speaker John Boehner makes a deal for $1 of spending cuts for every $1 increase in the debt ceiling, then the sequestration cuts will go away. The sequestration option was put in place in August 2011 only because an agreement on budget cuts was not reached. If Boehner gets those spending cuts via the debt ceiling negotiation, then sequestration won't be necessary. But I don’t think Boehner will get them; I think we will have a lot of piddling little steps instead. I think a rating downgrade is inevitable.

Brown: I agree. I think we'll be downgraded by both Fitch and Moody's. Moody's has said if Congress can't make any progress on the deficit, then they'll do the downgrade. Congress is unlikely to have made any progress on sequestration by the deadline on February 28. And members haven't even started the discussion on entitlements.

Over the next several months, we could possibly face the same distress over congressional dysfunction that we experienced during the original debt ceiling debate in July and August 2011. I think what really caused distress in the market was not the debt per se but the fact that the government didn't appear capable of functioning. The Dow Jones Industrial Average² dropped by about 1,800 points during those two months, though this was partly due to the turmoil in Europe at the time. Now, Europe seems to be in better shape; but if in the next few months Congress is again unable to reach an agreement on the debt ceiling, that distress could become evident in the market again.

Q: If Congress doesn't address entitlements, what impact is that likely to have on markets?

Brown: If Congress doesn't address entitlements, there will be no credibility to the budget. Everybody knows that is where the big problems are, and if Congress doesn't address them, then that leaves only a very small portion of the budget to work with.

Ezrati: I think the market doesn't expect anything from these budget negotiations. If President Obama feels really pressured to do something on entitlements, he'll appoint a commission. But he has said that he doesn't think we have a spending problem. So, I would be very surprised if Congress addressed the problem, and I would be surprised if the market is shocked by that.

Brown: I think some of the increase we've seen in the market this year is due to hope that something is going to be done. I expect significant market disappointment if Washington can't come up with some kind of an agreement this year.

Ezrati: We can agree to disagree on that. Care to break the tie, David?

Linsen: The market discounts many factors. In addition to what Zane mentioned about the U.S. budget negotiations, the market appears to be pricing in accelerating worldwide economic growth. Supporting this, year to date, in the Russell 1000^® Index,³ two cyclical sectors, energy and industrials, are two of the three sectors leading the market, which suggests the market is starting to price in higher economic growth.

Q: The sovereign debt crisis in Europe has eased lately. Has the worst of it passed? What can we expect this year?

Brown: Certainly, the market believes that the crisis is passing. At one point, yields on Greek debt were above 30%, and now [as of January 22] they're down to around 11%.⁴ Yields on Spanish debt had risen to 7.75%, and now [as of January 22] they're down to around 5%,⁵ which is lower than the average on U.S. debt over the past 30 years. So, I think investors have put their faith in ECB president Mario Draghi, and they believe that he is going to do just as he said—"whatever it takes" to keep the euro together.

Ezrati: Greece is not yet making much progress on its deficits, however, because its economy is in recession. The deficit continues to exceed the targets that have been set, but the ECB and the IMF, which are providing liquidity, approve of the austerity programs, and so even though the deficits have become larger, the money is forthcoming.

It's not that things are getting better in Europe, it's that for years now people have been expecting the euro to fail, and now there's reassurance that it won't. But that may not last. The Germans have an election this year, and that could be even more dangerous to the austerity programs than the Italian elections.

Brown: But there have been real reforms. There has been an easing of labor restrictions, even in France, giving employers the flexibility to lay off workers when necessary. In the long run, those reforms should make France and the other troubled countries more competitive. In Greece, public-sector wages and pension payouts have been cut, and reformers there have been able to do something that we haven't been able to do yet, which is to raise the retirement age. Public-sector workers now have to work until age 67, the highest in Europe. So, even Greece has seen improvement. Six months ago, it was living day to day. Now, it is living quarter to quarter. That's improvement.

Q: Japan's new prime minister, Shinzo Abe, is committed to a policy of devaluing the yen as a way of reinvigorating Japan's exports and its economy as a whole. How significant will this change be?

Brown: The currency is already 10-15% cheaper than it was a few months ago, and that has to help an export-driven economy. That 10-15% advantage should go a long way in helping Japanese exporters increase their sales. So, if there is additional depreciation as a result of policy changes under the new administration, then that could carry significant economic impact.

The United States may be among the parties that will be hurt, but the Federal Reserve has been easing as well, and will continue to ease through this year and maybe into 2014.

Ezrati: One interesting thing about Japan's planned devaluation is that it's going to buy foreign debt, which is a less obvious means of manipulating the currency than it has used in the past. It also means Japan will be able to buy more of our debt.

But this change in policy is only a big deal if your investment horizon is 18–24 months. Japan has two elections over the next 18 months, so over the next year, Prime Minister Abe has to goose the economy, and over that time period I'm confident that Japan's economy will look stronger. Exports are likely to improve, the government will likely pour money into infrastructure (and their debt could rise to 240% of GDP), and these efforts should benefit the Japanese economy and the world economy. But they won't address the fundamental problems, which include heavy regulation, lack of innovation, and a rapidly aging population.

Japan has been able to support a high debt-to-GDP ratio⁶ because its government bonds are mostly bought by the Japanese themselves, and those bonds are still attractive to domestic buyers. Although the yields are only about 0.5-1.0%, deflation has been running at about 2%.⁷ So, the real return is 2.5-3.0%.

The Japanese government can't rely on Japanese savers indefinitely, however. The population has gotten older and is now spending more and saving less. The savings rate has been falling, from about 15–20% 10 years ago to about 3% today.⁸

Brown: Because so little of Japan's debt is owned by foreign investors, there is little danger of "bond vigilantes" selling it off, as they have done to the debt of Greece, Spain, Italy, and other countries during the sovereign debt crisis. But if this new policy brings about a 2% rate of inflation, as intended, then that will ultimately result in upward pressure on yields.

Ezrati: If inflation in Japan gets to 2%, that is likely to change the equation. Investors would probably worry about capital losses. Presumably, yields would then rise, and the bond vigilantes would ride in Japan, but I'm skeptical Japan will get to that level of inflation. It's been trying for years, without success. The plan to double the consumption tax next year will also make that difficult.

Q: Where should investors consider looking for healthy returns in 2013?

Brown: They should not look to Treasuries. I think it likely that those yields will inch higher. Yield on the 10-year note could go above 2%, but probably not much beyond that, because that would work at cross purposes to the Fed's goal to keep mortgage rates low. If Treasury yields rise too much, then yields on mortgage-backed securities [MBS] likely would rise as well because the yield spread between them is currently minimal, and higher MBS yields would make home mortgages more expensive. So, there is some upside risk to safe haven yields, but the Fed probably won't let them rise too much. But still, there's not a whole lot of value there. And after taking inflation into account, you're likely to lose money in high-quality fixed income.

On the other hand, high-yield bonds, having generated healthy returns in 2012, should still be attractive. They still offer relatively attractive income, with a nearly 6% yield [as of January 22]⁹. Yield spreads have narrowed, but there is still room for some price appreciation. I think equities are likely to do better, but if an investor is interested in fixed-income securities, high yield and even the lower tiers of investment-grade, single-A and triple-B corporate bonds are currently attractive.

Linsen: The last several years have been about the "tail risks" [that is, rare events that make a large impact on a portfolio] and macro factors, and the market has experienced high intra-sector correlations. We think that 2013 and 2014 will be more normal, with intra-sector correlations running lower. If that's the case, then stock picking will become more important as company fundamentals become more important in determining winners and losers.

As for value versus growth, value stocks are skewed toward financial and energy sectors, so if housing continues to improve and if energy prices respond to stronger emerging market growth, then value stocks could perform better than growth stocks.

Ezrati: Earnings are likely to be reasonably strong in 2013. Profit margins have been high for two or three years now, and if they hold for another year, then earnings growth should essentially match the growth in revenues, which I'm estimating at about 6%.

Brown: Revenues can also be enhanced by growth outside the United States, and as in 2012, per share earnings can be meaningfully boosted by share buybacks.

Ezrati: Significant increases in inventory spending and capital expenditure could bring profit margins down slightly, however. But the assumption of my conservative scenario is that margins will remain where they are now.

Linsen: Another factor in the margin equation is hiring. If hiring accelerates, that may be negative for near-term margins, but very positive for demand growth, and a good catalyst for higher market levels.