Italian political worries hail return of Euro woe

There is no lack of chicken licken impersonators

REMEMBER when Europe stumbled from one crisis summit to the next? Asking: “Is Italy the next Spain? Is Ireland the next Greece? Is Portugal going to follow Spain?” Well, the good news for anybody nostalgic about those times is that, with last week’s election results in Italy, those headlines are back.

Last week’s elections produced a hung parliament with no party capable of forming a working majority. With European governments not known for their swiftness of action in resolving government impasses (see Belgium), many have been spooked by the potential fallout of a failure to maintain control of Italy’s €2 trillion (£1.72 trillion) of government debt.

Morgan Stanley yesterday put out a note on Italy saying that it sees a 30 per cent chance the country will return to crisis mode and further elections. As its base case, the bank has Italy being able to form a government, albeit a weak one, with the Eurozone crisis “contained – not resolved”.

The bank assigns a subjective 70 per cent probability that another round of elections can be avoided in Italy, but only a 10 per cent probability that such a government will be strong and stable.

MARKET REACTION
You might think that the political instability of a Eurozone country with an economy the size of Italy’s might have been enough to knock the wind out of the sails of European equity strength. But while the MSCI Europe index shed 0.3 per cent, this barely registered against recent gains.

Italian government debt also had a muted response to the country’s inability to form a government. But this may be because a larger spike in yields was mitigated by the European Central Bank bond buying backstop.

But relatively free of central bank mitigation, it is the FX markets that have most voiced their displeasure at Italy’s situation. Perceived haven currencies, including yen and dollar, strengthened on global risk aversion. euro-dollar broke below $1.30 as investors switched out of euro positions in favour of the greenback. The euro has not been helped by Italian worries coming at a time of record unemployment in Greece and Italy, combined with weak macro data almost across the board.

So are we going to see a real return to the chicken licken markets of 2010-2011, with analysts running around yelling that the sky was going to fall in on Europe? The answer depends on Italy resolving its political conundrum and convincing the markets that it is not going to abandon all efforts at dealing with its huge debt woes.