Renewed political turmoil in Spain and Italy shattered recent optimism Monday that Europe was becoming less of a threat to the global economy.
In Italy, opinion polls showed disgraced former Prime Minister Silvio Berlusconi closing to within 5-6 points of the center-left front-runner, less than three weeks before an election.
Berlusconi's anti-austerity pledges have helped voters look past his recent tax fraud conviction and charges that he had sex with an underage prostitute. He also has tied a bank scandal and bailout to his opponents.
In Spain, media reports that Prime Minister Mariano Rajoy received money from a slush fund run by his political party are leading to calls for his resignation. He has denied the accusations.
Italy's main stock index dived 4.5%, and Spain's tumbled 3.8%. Sovereign bond yields also rose. Other European stock indexes sold off sharply, as did U.S. stocks.
The market fears could end an upswing in European confidence. The Sentix investor sentiment gauge rose for the sixth straight month in February, with expectations at the highest level since June 2007.
Global stock markets have rallied in recent months as fears of a eurozone collapse receded.
All Roads To Rome But the upcoming Italian election on Feb. 24-25 increases the odds that the eurozone's No. 3 economy will be the next major crisis flash point, said Bill Adams, senior international economist with PNC Financial. Spain is a question mark too.
"Pick your poison," he said. "The accusations against Rajoy don't look very good either.
An election in Spain isn't expected for a few years, but the outcome of any snap vote is uncertain, he said. Amid a deepening recession and 26% unemployment, dissatisfaction with austerity measures and the economy could boost extreme fringe parties as well.
A weekend poll found 77% disapprove of Rajoy, and 54% want an election to be called.
But the concern over Spain has less to do with austerity being rolled back and more with the prospect of worse relations with Europe's leaders, who have worked well with Rajoy to manage Madrid's crisis, Adams said.
Indeed, German Chancellor Angela Merkel told Rajoy on Monday that she has confidence he will push through structural reforms and pledged to support his efforts.
Even if Rajoy stays in power, some fudging of Spain's austerity targets was expected, given the severity of its recession. But until recently, Italy's center-left looked like it would coast to victory and largely continue with the current reform path.
A Berlusconi victory and fulfillment of his promises would derail Italy's progress toward sustainable fiscal policy, Adams warned.
Tu Packard, a senior economist at Moody's Analytics, said Berlusconi would be "dreadful" for Italy because it would give rise to more corruption and waste.
"Italy, because of the Berlusconi threat, is more at risk" than Spain is, she said.
Whoever leads Spain has less leeway to ratchet back austerity due to the intense market backlash that would come, she added.
Political turmoil in Spain and Italy will be substantial risks as long as Europe remains stuck in recession, despite the signs of easing anxiety, Adams noted.
"The improvement in the real economy has lagged far behind the improvement in investor and business sentiment."