A Boot Right Into The Face: Immediate Implications​ Of The Italian Elections‏

Includes: SPY, TVIX, VXX, XIV
by: Ariel Aharonovich

This is exactly what we should all fear in the current market environment!

While here's no doubt in regard to the limitless support that decision makers - politicians and central banks - are willing to provide the markets through very loose monetary policies, it's clearly impossible to predict the people's unwillingness to cooperate with the austerity measures that come along with these very same policies.

This is exactly what happened in Italy earlier this week, when the "Italian people" sent a clear message to the rest of world: No more!

No more cooperation, No more austerity measures, No more super Mario (Monti).

Alternatively: Bunga-Bunga - here we come!

Since austerity measures seem essential in the EU/ECB ongoing policy - without the implementation of these measures Italy won't be able to use the ECB bond purchasing program, even if it wishes to - this is a worrying sign and an important junction.

As much as we may be certain that the ECB, i.e. Mario Draghi, will do "whatever it takes" to keep the euro intact, we may very well be extremely concerned with the European political instability that is expected to increase as we move forward into 2013. The rise of the anti-establishment movement led by ex-comedian Beppe Grillo is the strongest proof for this dangerous outcome.

The "Five Stars" movement, led by Grillo, was established only three years ago and its entire existence is based and dependent on the "cool" character and funny person that leads it. Through sharp criticism, mainly against banks (as well as against minorities, e.g. Jews), the movement succeeded well and beyond anyone's wildest dreams and collected the highest number of voters than any other single party received in this elections.

Here is the "man of the hour" in an updated, representative and very relevant photo:

The bottom line of the Italian elections is crystal clear - The country has been divided into three, very different, parts:

  1. The center-left coalition led by Pier Luigi Bargain.
  2. The coalition led by controversial three-time prime minister Silvia Berlusconi.
  3. The Five stars movement, which tries to unlink itself from any of the "old politics" members/coalitions.

In light of these very strict divisions the most reasonable outcome is another set of elections in the very short term. It seems impossible for any of the leaders/parties to form a stable coalition that can rule for more than a short while and, as many people put it, Italia became "unsovereignable." Italy is too big and too important for Europe to allow such an outcome. The main problem is that new elections can make things even worse.

At the moment, the center-left coalition has control over the lower house but not over the upper house = the Senate. Even in the lower house the results are so tight that Berlusconi is demanding another count because he claims that the results are too tight and therefore it's impossible to declare a winner.

Bear in mind that the party/coalition that receives the majority of votes is the one that assumes control over the lower house. Therefore, in spite of the "Five Stars" party receiving the most votes out of any single party in this election, thank to the coalition that was formed (pre-elections) by Bersani he is the one that obtained majority.

Unlike the lower house, in the senate none of the parties/coalition can assume control.

One of the possible solutions is a national unity government that on one hand would provide the stability that everyone is hoping for but on the other hand may lead Italy into complete paralysis. Either way, this is a very unwelcome result and a situation that creates lots of nervousness and uncertainty.

As we all know - nervousness and uncertainty are a combination that markets don't like at all. This is a for-sure recipe for risk off mode and so did the markets react.

As we have seen so many times during the last couple of years during such times the USD and the JPY rise, equities and commodities tumbled, U.S. treasury yields sank and the VIX ("fear index") soared. Definitely not a surprise...

The Italian election results are a painful punch to the European stabilization ongoing efforts. More than anything, the defeat of Mario Monti shows how deep is the distrust and how severe is the discomfort. This is the most compelling evidence that the person who enjoyed the massive support of markets, corporations and central banks around the world has lost creditability amongst his own people.

And as if this wasn't enough, Reuters has published that the Spanish prosecutors questioned the former treasurer of Prime Minister Mariano Rajoy's party in an inquiry launched following new allegations of corruption that have shaken the government.

Obviously, the market will be focusing on Italy this week. Yet, this is another sign of the growing fear over losing the political stability in Spain. Et Tu, Brute?...

Spain, just like Italy, is a country filled with furious people. People who lost their jobs, their wealth and their dignity are now also seeing their leaders dealing with allegations of corruption while they have to deal with and suffer from austerity measures.

What are the implications?

The markets left no room for doubt. The VIX soared 35%, the S&P500 (NYSEARCA:SPY) sank almost 2%, the USDJPY shed 4 points (!) in a single day and the U.S. 10-year Treasury note yield dived well below 2%.

There's no doubt that the markets don't like the recent Italian developments.

The markets "asked" for a reason to go down and they got it. As I projected here, here and here this was expected. What is usually unexpected is the catalyst that makes it happen. Well, at least for now, the "Italian Job" is indeed getting the (correction) job done.

The most troubling issue is the possible escalation of the current situation into an overall EU stabilization and preservations issues. There are elements - countries, parties, persons - within the EU that won't be sorry if Italy would be left alone and/or if the EUR breaks apart… Those elements have a different way of thinking than what we got used to since the EUR was launched.

I'm not saying that this is certain or that this is the most probable scenario but in the short run we are facing a situation with a high level of uncertainty that can definitely drag the markets down.

Obviously, the ECB is ready and willing to assist and if assistance will be given the markets will surely cheer. Nevertheless, one has to bear in mind that any type of assistance is subject to:

  1. An official request. Who in Italy can currently be considered "official"?
  2. Consent to more austerity measures. Who in Italy would agree to this in light of the elections results?

The "unsovereignable" Italy is currently stuck in a deadlock. There's literally no one to talk to and anyone you talk to may not have the mandate to talk to you.

This is where the greatest risk for the markets lies!

From an investment point of view the recent developments clearly call for a RISK-OFF play. In my previous articles I already touched upon the importance of being LONG VXX and TVIX or SHORT XIV. They are all allowing the investors to protect themselves and hedged their portfolios against higher volatility, which is almost certainly going to be on the rise.

Monday (February 25th) the VIX soared 35%, which was the 3rd-largest move since 2005 and the biggest one-day rise since November 9, 2011, from which the S&P500 (SPY) lost 6% over the following two weeks.

I expect this higher volatility trend to move on and even accelerate over the course of the next month, especially if the Sequester - as small as it seems (see below) - comes into effect on March 1.

I expect the S&P500 to go down another few percentage points and, therefore, I wouldn't buy the dips as of yet. If and when the S&P500 reaches 1450 I would start unwinding shorts or LONG VOL positions and get into more longs. I wouldn't be surprised if the S&P500 trades as low as 1400 but for this to happen we need more than "just" Italy.

Stay tuned. Interesting times ahead of us!

Disclosure: I am long VXX, TVIX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.