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Will Berlusconi Bring the Euro Crisis Back?

Italy goes to the polls in less than a fortnight...

SINCE the start of the year, the markets have been behaving as if the Eurozone debt crisis has been magically solved, writes Martin Hutchinson for Money Morning.

Yields on Spanish and Italian debt are trading more than 1% lower than at their peak, while world stock markets have soared close to all-time highs. Unfortunately, you can expect that all of this euphoria will fade when the Italian elections take place on February 23-24.

Why?...It's summed up in two words: Silvio Berlusconi.

That's because until recently a win by the former Prime Minister wasn't seen as very likely. Not long ago, The EU establishment believed they had the Italian elections completely wired.

The socialist "Democratic party" led by Pier Luigi Bersani was expected to win and be supported by a coalition of center parties led by the EU's favorite, Mario Monti, imposed as prime minister in November 2011.

Both of these candidates were safely pro-Euro, and prepared to put Italy through a fair amount of "austerity" to keep it, provided the handouts kept flowing from Germany and the European Central Bank. The status quo wouldn't be threatened.

Meanwhile, the two anti-Euro candidates were supposed to be comedians.  

One is an actual comedian named Beppe Grillo, leading an eccentric "Five Star Movement," while the other  is the aforementioned Silvio Berlusconi, who is currently under indictment for sex with under-age prostitutes and therefore (in the eyes of the EU bureaucracy) not seen as a serious threat.

At best it was thought Berlusconi and Grillo might get as much as 30% of the vote between them, but it wouldn't give them any significant power. 

Well, let's just say things have changed.

According to the latest polls, Berlusconi's party would get 30% of the vote on its own, while Grillo's would earn a solid 15%.  Not bad for a couple of comedians.

As for the establishment picks, Bersani's party still leads with about 34%, while Monti's supporters trail with around 12%.

That suggests a very close vote, or possibly (if as sometimes happens, voters are falsely claiming to opinion pollsters that they support the "respectable" parties) even a Berlusconi victory, provided he could come to a satisfactory arrangement with Grillo.

But here's where it gets slippery for the EU: Anything but a solid Bersani/Monti majority is bad news for the Euro, or at least for Italy's participation in it.

Here's why...

Italy's budget is in fact quite close to balanced (Berlusconi had repaired much of the damage done by his leftist predecessors) which means an Italian exit from the Euro – getting cut off from EU handouts and austerity programs – would be pretty painless.

However, if Italy left the Euro, it's likely that Spain, Greece, Portugal and very likely France would also be forced out.

But a Berlusconi return to power is not the only threat faced by the Euro these days. In Spain, Prime Minister Mariano Rajoy has been embroiled in a corruption scandal and the opposition is demanding his resignation.

Rajoy's government is making good progress on Spain's deficit, and avoiding excessive dependence on the EU, but if it's brought down, Spain's gremlins are free to roam wild. In any case, even with Rajoy in power, Spain's youth unemployment rate is an astounding 55%, so safe emergence from the crisis is by no means certain.

Greece, meanwhile, is entering its sixth year of recession, with unemployment above 25% and GDP down 20% from its 2008 peak. Politically, the leftist Alexis Tsipras is running ahead in opinion polls; apart from nationalizing anything available, he would also leave the Euro.

And then there's France, home of the 75% tax rate.

France's prospects have actually improved in the last month, with its troops sent to Mali. While economically this expedition will inevitably be a drain, psychologically the sight of French troops entering Timbuktu within a few weeks of their arrival has been an immense fillip to Francois Hollande's government.

However the folly of his policies hasn't gone away. Economically French prospects still look dire, although the markets are still not reflecting this with yields on French 10-year government bonds at 2.28%, up only 25-30 basis points from last year.

For investors that means the message is clear: you should expect further storms from across the pond.

Mind you, a combination of chaos in Europe combined with a successful implementation of the March 1 "sequester" cutting US public spending by $1 trillion could provide US investors with a "sweet spot," in which the US became regarded as the best prospect on the planet and US stocks soared accordingly as they did in the 1990s. 

So overall, investors should stay invested in US and Asian stocks, avoid Europe, and make sure their trailing stops are in place in case a sudden storm blows up.

We'll know more in just a few weeks.

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Now a contributing editor to both the Money Map Report and Money Morning, the much-respected free daily advisory service, Martin Hutchinson is an investment banker with more than 25 years’ experience. A graduate of Cambridge and Harvard universities, he moved from working on Wall Street and in the City, as well as in Spain and South Korea, to helping the governments of Bulgaria, Croatia and Macedonia establish their Treasury bond markets in the late '90s. Business and Economics Editor at United Press International from 2000-4, and a BreakingViews editor since 2006, Hutchinson is also author of the closely-followed Bear's Lair column at the Prudent Bear website.

See full archive of Martin Hutchinson.

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