Dispatch From Milan: The Most Likely Scenario For Italy

| About: iShares MSCI (EWI)

I’d long planned to travel to Milan this week to meet with Italian investors, but the fact that my trip coincided with political turmoil in Italy tuned out to be a lucky coincidence. My trip has allowed me to develop a much clearer picture of what Italy’s political turmoil means for the markets and why the next 72 hours are critical.

There is a consensus among investors I spoke with and — judging by news reports — among investors in general that last night’s appointment of Mario Monti to the position of senator for life is an important precursor to a deal for a new Italian government.

Based on my conversations, investors believe that the most likely deal scenario is that Berlusconi will finally bow to political pressure this weekend and resign, and Monti will be appointed prime minister to head a coalition government. Under this scenario, an imminent election would be avoided.

Why Monti for prime minister? He’s a respected technocrat, and Italian investors believe he can lead a caretaker coalition government that will implement the necessary reforms. One senior investor explained to me that by making him a senator for life, he is now prohibited from forming his own political party, a scenario that derailed another technocrat government in the mid 1990s.

Here’s the Best-Case Scenario: Assuming the most likely scenario happens – Berlusconi resigns and Monti becomes prime minister — I would expect global equities and other risky assets to stage a strong rally. This scenario would be a major, positive step toward implementing necessary reforms in Italy. Plus, once Italy starts to move down a path of reform, investors expect that the European Central Bank will be more willing to resume its bond purchase program.

Here’s the Worst-Case Scenario: The market implications if Berlusconi stays on and there is an election in early 2012 are far from cheery. This scenario would likely lead to a collapse in the Italian bond market, a strong likelihood of a severe European recession and a rising likelihood that the euro currency could break up. In addition, the risks of a banking crisis would also rise. Under this scenario, investors would want to consider lowering their allocation to risky assets.

The next 72 hours will be critical. Most Italians I spoke with thought an announcement about a government deal is likely over the coming weekend.

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