Italian voters went to the polling booths earlier this week, moving Europe squarely back into the international market spotlight. Pre-election polls had pointed to a relatively market-friendly and stable outcome whereby Pier Luigi Bersani’s centre-left Democrats would be able to form a government alongside the outgoing Prime Minister Mario Monti’s centrist party.

Markets did not get what they had hoped for, leading to a 3% fall in European stocks on Tuesday. Bersani took control of the lower house, but in the senate fell short of a majority alongside Monti. Given that control of both houses is required to form a government, this means that no obvious coalition exists to take control of Italy. Upsetting the outcome was Beppe Grillo, a new force in Italian politics. Campaigning on an anti-establishment, anti-corruption, and anti-austerity ticket, he took 25% of the vote through an internet-heavy campaign. He now leads 162 new MPs, most in their 20s and 30s, into the Italian parliament. The combination of a hung parliament and strong presence for the unknown Grillo makes for a highly uncertain outlook, even in the context of the Italian political system where surprises are never far away.

Why does this mean for markets? Italy is a significant economy, but not critical from a global perspective – it ranks as the fifth largest in the EU with less than 3% of world GDP. Importantly, its government debt comprises the world’s third largest bond market. If Italy’s economy were to slow sharply under an unstable government, it would be forced to borrow in the bond markets at much higher rates. At some point this becomes unsustainable and the country would be insolvent. This would lead to significant losses across the array of European banks, pension funds and individuals holding its bonds. To prevent a situation like this, last August the European Central Bank (ECB) announced a new set of measures (Outright Monetary Transactions, or OMT) that would allow it to step in and buy unlimited amounts of 1-3 year European government bonds. In doing so the ECB would restore a low, sustainable borrowing cost and prevent market panic spreading from one European economy to the next. Because of this, the introduction of OMT proved to be a key turning point in the Euro area crisis. Since its announcement the European stock market is up by 17%, and borrowing costs for Spain and Italy have plummeted.

The bad news for Italy is that OMT is conditional – it requires the government of a country in need to agree to a set of measures to restore its fiscal health. Without a functional government, Italy may not be able to reach any such agreement. The good news is that, now that OMT is in place, any problems in Italy are much less likely to spread to other European countries.

Looking ahead, in the short term Europe is in for an uncertain time over the next 4-8 weeks as Italian politicians search for a functional coalition. This will probably lead to a little volatility on global exchanges. Partly thanks to OMT however, a few bumps on the road for Italy should not derail the improving momentum across the global economy.

David Lewis

Investment Analyst