Italy's Latest Political Drama Changes Little for Investors or its Economy

Market reaction to the imminent departure of Italy's technocratic Prime Minister is as easy to understand as the contractions within Europe's third largest economy are difficult to comprehend.

Within days of sealing the principal achievement of his short tenure as Prime Minister, Mario Monti's plans to resign have triggered concerns over political turmoil and a potential retreat from hard-won reforms in a deeply-flawed economy that's struggling to exit its fourth recession in a decade. However, the steep decline in stock and bond prices immediately following the news ignores both Italy's potential to manage its turbulent politics and its people's commitment to the broader European project.

"Although markets would appear likely to welcome a 'Monti bis' (repeat) election outcome of some sort, we do question whether this would actually be for the best," wrote Normura investment strategist Alistair Newton. "A government with solid democratic legitimacy in the form of a majority popular vote could have more leverage to pursue the sort of structural reforms which Italy urgently needs to boost growth - in our view, the real issue rather than debt and deficit reduction."

Growth is certainly the principal concern at this stage, following the confirmation of a 2.4 percent annual contraction in Italian GDP Monday by the country's statistics office, ISTAT. Forward-looking indicators are similarly bleak as evidenced by a 1.1 percent plunge in industrial output last month.

In fact, the deepening recession underscores the sharp contrast in Italy's fiscal fortunes when compared to their southern European neighbours, in that many analysts have noted the country's resistance to running persistent budget deficits as part of the reason for its prolonged economic weakness.

Italy has only had one primary budget deficit (ie those which exclude the cost of debt interest payments) in the past twenty years, a condition which has kept it from riding the wave of growth enjoyed by other Eurozone members but which has also helped it avoid the kind housing and credit busts that have defined economic failure in Ireland and Greece.

The true concern from the investor perspective has been Italy's structurally imperilled labour and consumer markets, alongside a hopelessly byzantine political system.

Monti's reforms have come a long way towards addressing these weaknesses and the two-year Budget Law passage - expected in the next two weeks even without the support of Silvio Berlusconi's People of Freedom (PDL) Party - would have set in motion a near-permanent adjustment to key portions of the Italian economy. With his government's term set to expire in April, and with little time to achieve much else in the meantime, standing down in December will likely have very little impact on the previously agreed changes.

"All political scenarios are such that the direction of fiscal policy is set, even though there might now be some delays in passing some pieces of legislation," wrote Morgan Stanley economist Daniele Antonucci in a client note Monday.

Polls suggest centre-left reformer Pier Luigi Bersani - recent victor in the Democratic Party primary - will likely win an early spring vote but may struggle to form an outright majority government without first cutting a deal with one of the smaller centrist parties. Either way he'll easily outdistance the vastly diminished Berlusconi (who's polling under 14 percent) and his centre-right upstart, the former comedian-turned-politician Beppe Grillo's Five Star movement.

Furthermore, it's been suggested that Berlusconi's desire to re-enter politics owes less to the zeal of a 76-year-old man to embark on broad economic reforms than to a desire to avoid prosecution for tax evasion and engaging in prostitution with a minor.

Much has been made of both men's anti-austerity rhetoric and the promise of a referendum on EU membership, but much less has been explained with respect to the desire of most Italians to remain within the project. Even given their oddly contradictory stances to two of its three pillars.

Recent Pew Research data suggest Italians have the highest percentage of citizens in the Eurozone who think a return to their original currency would be a good thing, but also the second highest (after France) proportion of support for deeper EU control over their national budget - perhaps a reflection, or at the very least an honest understanding, of the fractured nature of domestic politics.

Against this backdrop, then, it could be argued that investors were looking for a purely political catalyst with which to remove risk from their portfolios in a market where European shares were trading at an 18-month high and benchmark Italian debt had rallied more than 150 basis points to a two-year low of 4.4 percent, following European Central Bank President Mario Draghi's verbal bond market intervention in July.

Morgan Stanely's Antonucci notes that benchmark short-term interest rates have historically risen by around 24 percent and stocks have fallen on average around 5 percent in the weeks leading to and after an Italian government collapse, only to largely retrace those gains once a new leadership has taken office.

That's to suggest there won't be major economic hurdles to overcome. Italian GDP is set for a prolonged 2013 recession that will need to include the raising of some €410bn in new government debt. Long-term potential growth, according to economist at both the IMF and the OECD, has fallen steadily from its 4 percent peak in the 1970s to a megeaure 1 percent today thanks to a permanent destruction in output capacity (linked to years of underinvestment) and its ratio of foreign investment dollars ranks as the second-lowest in Europe (and barely ahead of corruption-riddled Greece).

However, with more than 65 percent of total Italian debt in domestic hands (up from 48 percent in the summer of 2011), the impact of slowing growth on either bond yields or Italy's credit rating will be somewhat muted, leaving investors to re-affix their focus to the underlying issues of economic reform that led to the market advances Italy has enjoyed in the second half of this year.

"We doubt financial markets will materially change their assessment of the risk surrounding Italy as the term of elections would only move forward by a few weeks," wrote Barclays' economists Fabio Fois and Giuseppe Maraffino. "The focus is likely to stay on long-term drivers, in our view. In the eyes of financial markets, Italy needs to complete the reform agenda in order to raise long-term growth prospects."