Outlook For U.S. Stocks, The Euro And British Pound

Brian Kelly
updated | Author's Website

From the outset of the financial crisis the response by central banks and governments has been pure Keynesian – if you print enough money you can reflate anything. The fatal flaw in Keynesian logic is that Lord Keynes assumed a government could borrow at will.  As we have seen in the last week, this is not always the case.

Our global financial system is based on the simple tenet of trust – one party contracts with another and trusts they will be made whole on the transaction. When that trust breaks down, the system breaks down…this is what we experienced Thursday in the financial markets.

While many will spend the weekend retracing the path that got us here, we find it more useful to look forward and determine the most likely path ahead.

The Eurozone Endgame – Debt Restructuring
As we wrote last week in our Special Report: Europe on the Edge of a Debt Crisis, we believe the ECB is negligently behind the curve and must act quickly and decisively to stem the panic. In this report we presented three scenarios from best to worst, unfortunately the ECB has chosen door #3 and the worst case scenario.  The ECB and the EU have failed to properly address this crisis by immediately enacting quantitative easing, cutting interest rates and generally restoring confidence in the system.

Under our worst case scenario we opined that the market would punish Europe severely for this misstep and would push the Eurozone into a full blown debt crisis…unfortunately the Eurozone has arrived at its destination.

Now that confidence has been lost the end game for Europe is a debt restructuring for Greece, Portugal and potentially Spain. A voluntary restructuring is what the market is demanding and it will not relent until it is satisfied. The so-called austerity measures being enacted rely heavily on economic growth in Europe, given the events of this week we do not believe even mild growth is achievable in the Euro-zone.

The net result of a Eurozone debt restructuring will be a significantly lower Euro. We presented the chart to the righteurusd 5 7 10 monthly form jan to our institutional clients in January. At that time we added the caveat that if the ECB could short circuit the vicious spiral that was/is Greece then our targets may not be achievable.

The ECB has not only failed to short circuit the downward spiral they have added to the uncertainty. Given the social and political unrest in the Eurozone we believe a EURUSD rate at parity is well within the realm of possibility.

The “Flash Crash’ & The UK Endgame – Pound Devaluation
On Thursday the UK voters decided not to decide and stuck the UK with a hung parliament.  It appears that the worst of all scenarios has played out with not a single party have a clear mandate.  Over the next few days uncertainty will run rampant as the world watches the intracacies of a parliamentary system that will appear chaotic to the financial markets.

In the end, the UK has a formidable task on its hands – it must cut its budget enough to satisfy the ratings agencies -and more importantly the markets- while at the same time keeping the nascent economic recovery alive. The ‘Flash Crash’ may have been the straw that breaks the camels back. Confidence in the financial markets is shattered and any potential for the continuation of the bull run was deleted by yesterday’s robot ruckus. Given the fact that the UK economy is highly levered to the financial markets we do not believe the UK will be able to generate the GDP growth needed to keep its AAA rating.

The UK, unlike Greece, has the ability/luxury to print as many pounds as it wishes, therefore a debt restructuring is not likely. However we do believe the markets will continue to push the GBPUSD to our target of 1.2500.

US Equities? Lower
Simply put any hope that the retail investor would be the engine behind the next leg of the bull market vanished with the touch of a button.  Moreover, we do not believe in the myth of decoupling. Therefore, unless a miraculous solution to the European crisis arises over the weekend we do not foresee new highs any time soon for US equities.

In the begining of April we presented this chart with our ‘line in the sand’ of 1073 – at that point in time we did not believe that level would be achieved in one day!spx 4 1 10

Our technical view is that a close below 1073 would signal the end to the bull market and the begining of a significant correction at best and new downtrend at best.

The ultimate manifestation – downtred or correction – depends wholly on market confidence. We are quickly approaching the point of complete loss of confidence – if left unchecked a new downtrend will develop pushing the S&P 500 below the March 2009 lows.

Disclosures: short GBPUSD, EURUSD

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