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Are Markets Underestimating Italy's 'Joker in the Pack'?

A giant paper mache float representing Italian comedian and politician Beppe Grillo moves through the streets of Viareggio, Italy.
Laura Lezza | Getty Images

Markets are underestimating the risk of a surprise election result in Italy and the possibility of new elections within the year as support for "protest" parties in the country grows, analysts have warned.

Beppe Grillo, a comedian turned politician who has attracted huge support, has become a serious contender and could attract votes away from the country's traditional parties as voters express their frustration with established politicians. His popularity could have significant consequences for Italy's economy.

"Grillo is someone to take seriously," Wolfango Piccoli, director of the Eurasia Group, told CNBC on Wednesday. "He is taking votes from all sides, from disaffected voters on the center-left, the center-right…he is third [in the polls] and is still on the rise," he added.

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"It's got the potential to be messy," Piccoli warned investors. "It's a strange election, it's not an election among strong candidates…the one who is going to come out strongly and potentially could be the surprise of this election is Grillo…I would be careful."

Polls before the blackout showed that center-left and pro-European candidate Pier-Luigi Bersani is the election front-runner followed by former premier Silvio Berlusconi around 6 percent behind. Grillo was in third place and Monti's centrist bloc is in fourth.

Grillo's movement campaigns predominantly on an anti-Europe, anti-austerity and anti-euro message. He could mop up even more votes in the wake of financial scandals involving high profile politicians.

Analysts believe that the more likely scenario is a victory for Bersani. He is expected to form a coalition government with technocrat Mario Monti to give the center-left a majority in the Senate. In a televised debate on Tuesday evening, Bersani said he could form a coalition with Grillo, but Grillo has said he will not accept a tie-up with one of his opponents.

He told CNBC in an interview earlier this week that his party was "unstoppable" and the old political class "should leave".

Those differences could prove problematic for Italy in the wake of the elections, analysts warn. Investors could be unnerved by an unstable coalition government, potentially pushing the country's borrowing costs higher once again.

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"It's not just the risk of an anti-austerity and anti-establishment backlash [that is being underestimated]," Nicholas Spiro, managing director of Spiro Sovereign Strategy, told CNBC.

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"It's the significant policy differences between and within the main parties contesting Italy's election - particularly in the case of the Monti and Bersani alliances. These can, and probably will, be papered over in government but they are likely to remain significant, boding ill for post-election stability," he said.

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The Eurasia Group predicted that a potentially fragile coalition between Monti and Bersani could ultimately be undermined by Berlusconi, should he try to block legislation on reform in the Senate.

"The short-term aim of Berlusconi is to mount significant resistance in parliament, making life for the next parliament difficult and basically trying to trigger an election which. In our view, is not far away," he said, with the best case scenario that an election takes place within twelve months.

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"An upset victory for Mr Berlusconi may be markets' nightmare scenario, but the prospects for a stable and harmonious Bersani-Monti coalition government - still the mostly likely outcome in our view - are bleak," Spiro added. "We believe Italy is headed for post-election instability, with disagreements over the pace and direction of economic reform."

Spiro added that even if Bersani ends up winning more convincingly than expected, the reaction on the part of investors could prove deceptive with a market rally that soon gives way to doubts about Monti's role and/or Bersani's commitment to meaningful reforms.

Investors Unaware

For the time being, investors do not appear concerned. Stocks were relatively unchanged over the last month. Two-year bond yields have risen from 1.46 percent to 1.61 percent over the last month.

But one senior market analyst warned that an uncertain election result would see bond yields soar again. "If there's uncertainty after the result, the first thing you'll see is a spike in bond yields up to the 5 percent levels seen in November," Michael Hewson at CMC Markets told CNBC.

Italy's borrowing costs fell sharply with Monti's arrival, and his commitment to economic reforms helped calm investors' nerves. The ECB's bond-buying program known as Outright Monetary Transactions (OMT) also eased tensions, but that safety net is dependent on a commitment to economic reform.

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"Central bank support in the form of OMT is dependent on reforms being implemented - but if they can't even decide on a government, how will they implement a reform package?" Hewson told CNBC. "Equity markets could be hit very hard. ECB support is conditional on politicians sticking to the plan. It could end up withdrawing that support," he said.

Eurasia Group's Piccoli agreed that investors were "trading the floor, not the fundamentals".

"The outlook for structural reforms which Italy badly needs –this is country that has not been growing for 10 years –is not a particularly bright one,"Piccoli said.

Figures released on Wednesday showed a sharp drop in orders in Italy at the end of 2012, falling 1.8 percent in December from a month earlier and 15.3 percent from a year earlier. The figures, which reveal future demand, do not bode well for a struggling economy in its sixth consecutive quarter of economic contraction.