Italian Elections Hammer Stocks, Bonds On Fears Of Policy Gridlock In Europe's Third-Largest Economy

Pier Luigi Bersani's center-left coalition, the pre-election favorite, won by the thinnest of margins and may form an alliance with outgoing Prime Minister Mario Monti’s party. A late surge by former Prime Minister Silvio Berlusconi's People of Freedom center-right coalition, and a surprising showing by comedian Beppe Grillo's protest-minded Five Star Movement, eroded the center-left's advantage in the polls, which had been as high as 10 percentage points in late 2012. The results spelled policy paralysis for the markets; in Italy, Europe's third-largest economy behind Germany and France, Italian stocks plunged Tuesday by 4.6 percent before beginning to trim those losses to 4.4 percent. The spread between Italian government bond yields and the benchmark German government bonds grew to 33.23 -- a level not seen since Dec. 12, 2012. "Italy looks set for a potentially long period of political uncertainty, which is likely to prompt government bond yields to continue to climb higher," Capital Economics said in a note.  "Of course, the possibility of bond purchases by the European Central Bank might stop yields rising back to or above the supposedly critical 7 percent threshold. Nonetheless, given the particularly bleak economic backdrop for Italy and the growing risk that the next Government will at best have a limited mandate to continue the reform process begun by Mario Monti, we would not be surprised if a sustained bout of market pressure were to force Italy to eventually to request some form of support package." Beyond the effect on Italian politics and finances, the nation's elections could raise the specter of continent-wide troubles -- even threatening the existence of the euro zone itself. "The general election results throw up an interesting conundrum to EU/ECB policymakers," wrote Raj Badiani, an IHS Global Insight analyst, in a note. "Although Italian voters appear to support membership of the euro, they are not prepared to accept the constant pain that is required to secure Italy's position as a dynamic, competitive and lean member of the single currency region. The euro zone without Italy is unthinkable, particularly with German and Italian exports sharing the same profile while competing in the same export markets across the euro zone. German exporters would take fright at the prospect of trying to compete with their Italian counterparts enjoying an overnight and steep boost to their competitiveness by returning to its legacy currency."