Italy's power struggle could be a flashpoint for market 'contagion'

  • "If you just look at the economic fundamentals of Italy, they are worrying," Mouhammed Choukeir, chief investment officer at private bank Kleinwort Hambros, told CNBC's "Squawk Box Europe" Tuesday.
  • Italy's 10-year yield surged another 50 basis points by 11.00 a.m. London time. A bond yield moves inversely to the price.
  • Spain, specifically, is facing a confidence vote this week for its leader Mariano Rajoy.

The contagion risks from a potential Italian implosion should concern market participants once again, according to analysts.

The euro zone's third-largest economy is currently in the midst of an ongoing power struggle, with investors fearful the looming prospect of snap elections could be fought over the country's role in the European Union and its membership of the single currency.

Rome's deepening political crisis has prompted a second consecutive session of heavy selling in European financial markets Tuesday, with stocks tumbling and the euro slipping to fresh six-month lows.

"If you just look at the economic fundamentals of Italy, they are worrying," Mouhammed Choukeir, chief investment officer at private bank Kleinwort Hambros, told CNBC's "Squawk Box Europe" Tuesday.

"It is one of the biggest indebted countries in the world … it's got an unemployment rate of 11 percent and its economy is still lower than where it was in 2007, whereas most major economies have recovered. So, clearly there is a requirement for structural reform here in order to regain confidence," he said.

"(Last year) was a stellar year for economic growth in Europe, we've seen a resumption of inflation so those deflationary fears went away and it almost happened in a flash … Now everybody is concerned about potential for deflation and even potential for contagion," he added.

European banks hit hard

Usually associated with a financial meltdown, contagion refers to the spread of market disturbances from one region to others.

Among national indexes, Italy's FTSE MIB slumped over 2.5 percent during mid-morning trade Tuesday, while Europe's banking index fell to 13-month lows amid a steep sell-off in Italian government bonds. The index was on track to register its worst daily loss in 21 months, while excessive losses forced some lenders to halt trading.

Investors fear a deeply divisive election campaign could deliver a euroskeptic government prepared to break up the bloc. The renewed concerns over the future of the European Union prompted Sentix's euro zone break-up index to climb to its highest level since April 2017 — when France's Marine Le Pen campaigned for the presidency.

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Yields on government bonds from other euro zone nations also climbed Tuesday, showing investors are concerned about lending to countries that share the euro. Spain, specifically, is facing a confidence vote this week for its leader Mariano Rajoy. Italy's 10-year yield surged another 50 basis points by 11.00 a.m. London time. A bond yield moves inversely to the price.

Italy is Europe's 'top political risk'

Italy has been without a government since an inconclusive vote in early March, with anti-establishment political groups abandoning their efforts to form a coalition over the weekend amid a dispute with the country's head of state.

President Sergio Mattarella, who was installed by a previous pro-EU government, refused to accept the nomination of euroskeptic candidate Paolo Savona for economy minister on Sunday.

Instead, he set the country on a path to another snap vote by appointing former International Monetary Fund (IMF) official Carlo Cottarelli as interim prime minister. Cottarelli, who became known as "Mr. Scissors" for his reputation regarding cuts to public spending in Italy, is now tasked with the planning of fresh elections and passing the next budget.

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The decision to appoint Cottarelli to form a temporary administration prompted the Five Star Movement (M5S) and the right-wing Lega party (League) to switch back to campaign mode. Both parties had already accused Mattarella of betraying Italy's electorate by blocking Savona's nomination.

"Italian politics has been our top political risk in Europe ever since then-Prime Minister Matteo Renzi started to lose support in mid-2016 for his ill-fated constitutional referendum … (However) European authorities would likely act swiftly to contain any contagion risks if required," Holger Schmieding, chief economist at Berenberg, told CNBC in a research note published Tuesday.

"In the unlikely case of a messy Italexit, euro zone growth (outside Italy) may stall for a couple of quarters while the authorities deploy their tools to contain contagion risks and shore up the most affected banks if required. Thereafter, growth would likely recover back to a healthy pace, at least outside Italy," he added.