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Italy Again In the Spotlight, and It's Not Good

- By Matt Winkler

Beware the 4th of March. It could be a Black Swan event emanating once again from Rome, though this time 11 days earlier than Julius Caesar's infamous assassination.

On March 4, Italians go to the ballot box, and the populist parties Five Star Movement and the Northern League (Lega Nord) together command over 40% of the vote in the most recent polls. Both are making their appeals to voters by essentially lambasting the E.U. and the eurozone monetary union. The Northern League says it wants changes to E.U. fiscal treaties. That's code for saying it wants to be able to put the Italian public even deeper into debt than the dangerous 133% of GDP it already has. The League has said explicitly that it will go against the E.U.'s deficit-to-GDP rule if it is rebuffed by Brussels from doing so mutually.

With a few minor differences, the Five Star Movement holds by these principles as well. In their eyes, Brussels has been "punishing" Italy by forbidding the state to go even deeper into debt. If these parties win enough seats to form a coalition, Italian stocks are going to tank as a Greek situation in Italy unfolds. This won't necessarily happen in terms of a bailout package, which would be impossible, but because negotiations between Brussels and the Italian government go in circles, with Brussels necessarily winning because in the end, Rome has no real leverage over Brussels. It's like threatening to leave your parents' house when you have no money and no good job prospects.

Greece threatened to leave the euro, but in the end its bluff was called, and so, too, here. Under a Five Star-Northern League government, Italy's negotiating position would not be a direct threat to leave the euro, but more like, "Let us go even deeper into debt, or we'll do it anyway and the ball is in your court." Following through with that threat would put Italians through more misery than they are in now because all Brussels would have to do is threaten to sell Italian bonds on the open market, causing steep rises in Italian interest rates that could bankrupt or at least severely strain any new government, and could even cause riots in the streets as happened in Athens.

Let's not forget that the European Central Bank is the financier of Rome, so Rome really has no negotiating positions even though some of its politicians are blustering about. There will be a fight, then eventually Rome will kowtow to Brussels, and in the meantime Italian stocks and bonds would suffer greatly.

Even if neither party heads a coalition and the next Prime Minister is chosen from a different party, either may be able to demand fighting the ECB by threatening to shirk eurozone deficit rules to go deeper into debt in exchange for parliamentary support. The fight would end the same way, but it would cause similar turmoil in Italian debt and equity securities.

Investors can position themselves by shorting the iShares MSCI Italy Capped ETF (EWI) ahead of the elections to hedge against contagion, but should also expect Italian stocks to have a relief rally, perhaps even a strong one, if both parties do worse than expected and don't make it into the coalition. Bottom line, shorting the iShares MSCI Italy Capped ETF can be used as a hedge rather than an outright bet.

Disclosure: No positions.

This article first appeared on GuruFocus.