Roughly 18 months ago, I spelled out the relationship between economic growth and the stock market. 

My key takeaway still stands: “The difference between 2% and 3% (economic growth) may not seem like much, but it is.” Although it is an inexact science, quarterly gross domestic product (GDP) has subsequently been a pretty good harbinger of stock market activity. The market rallied nicely higher in the fourth quarter of 2011 and the first quarter of 2012, at a time when GDP growth averaged roughly 3%.

And it’s no coincidence that the S&P 500 has risen just 3.6% since the end of 2012’s first quarter. The economy has had only one decent period of growth in that time (the third quarter), and JP Morgan cautions that the end of 2012 finished on a weak note. (The official government figures will be released on Jan. 30). 

February’s noise
Right now, clear signs are emerging that the U.S. consumer is ready to boost spending. As I noted in early January, consumer debt loads are now in reasonable shape and households again have the capacity to increase borrowing.#-ad_banner-#

Yet as I noted back in December, economic data points emanating from the corporate sector are not nearly as robust.

Still, on balance, the U.S. economy is giving off signs of increasing strength. And with a few breaks, we may finally be headed for a period of sustained 3% economic growth — which would help stocks move up to fresh highs. For example, UBS’ Maury Harris expects the U.S. economy to grow 2.1% in the current quarter, 2.8% in the second quarter and at a 3% to 3.5% pace in the second half of 2013.

But before we get there, we have another mountain to climb. Whereas the past few quarters have been characterized by a looming “Fiscal Cliff,” this coming mountain of worry can be laid squarely at the feet of Washington as well. By the end of next month, Washington will need to address the hard choices that it deftly avoided a few weeks ago.

Signs are emerging that Republican members of the House believe they have already made all of the tax concessions that they are going to make. “No new taxes” is this current rallying crew, which ostensibly forces President Barack Obama and Democrats to chip away at the budget crisis solely through spending cuts.

There are two problems with this. First, President Obama and Democrats are likely to make a strong push for more tax changes, likely in tandem with proposals to overhaul entitlement spending. But unless one or both sides are willing to make major concessions, get ready for another market-rattling showdown in the next four-five weeks. The media will likely again focus on apocalyptic government shutdown fears, and the market hates that kind of uncertainty.

The other key problem: even if the two sides manage to make real progress, then you can count on spending cuts that will make it hard for the economy to grow at 3% later this year, as UBS’ Harris anticipates. Economists figure that the ultimate budget agreement that arrives will trim GDP by 1% to 2%. This means the private economy would have to generate an organic growth rate in excess of 4% to offset that drag. And that’s quite a stretch.

Before we start to look out over the course of 2013, you need to stay focused on the current quarter. Even as investors are digesting the results of earnings season, they’ll be keeping one eye on the economic calendar — especially with regards to corporate America. Here are three key economic data points that will arrive before the coming government budget talks really heat up again. Each of these data points will give a clear read on whether Washington’s intransigence is starting to materially affect corporate spending plans. 

• Jan. 15: Business inventories. Companies halted their regular spending patterns in the fourth quarter of 2012 due to Fiscal Cliff uncertainty, sharply blunting fourth-quarter GDP figures. Investors will find out on Tuesday — and again a month later — how the next round of government budget talks/uncertainty is affecting spending on inventories.

• Jan. 21: The Chicago Fed National Activity Index. The CFNAI posted a surprise rebound in November, the first positive reading since last March, though the three-month moving average remains negative. We’ll get a fresh read for December when the Chicago Fed releases its latest look next week. This reading will come near the peak of earnings season for large-cap stocks, and taken together, we’ll have our deepest read yet on business sentiment for the months ahead.

• Feb. 1: Purchasing Managers Index (PMI). This gauge of corporate sentiment shows an economy that is just barely moving forward: most subcomponents that make up the gauge have been barely above 50.0 in recent months, which is the difference between expansion and contraction. Yet in last month’s report, the survey noted a cautious tone among the businesses polled: “Many respondents express uncertainty about government regulations, taxes and global economics in general as we approach 2013.”

Risks to Consider: The markets are off to a solid start in 2013, and analysts generally expect the current earnings season to be mostly positive, especially since analysts sharply lowered their forecasts for the quarter in recent weeks. Still, tepid forward guidance could create just enough noise in the market as we head into the crucial month of February when government budget talks heat up.

Action to Take –> If the market and the economy can survive the next six weeks without too much damage, then the stage may be indeed for a rising economy in 2013. And if we start to head toward a 3% GDP growth rate later in the year, as UBS anticipates, then the S&P 500 would likely be poised for yet another year of double-digit gains.