26/02/2013 06:11 GMT

Italian Election Impasse Sends Jitters Across The Markets; Instability Leading To Sell Off

The FTSE experienced its first major fall for weeks on Tuesday after the Italian election results failed to produce a clear winner.

Italy, as Europe most indebted state with public debts amounting to over 120% of its gross domestic product, is currently in a political vacuum after no overall majority was elected for its two political houses; the Senate and the lower house.

Pre-election favorite Pier Luigi Bersani won the lower house, but only by less than a half a point. Silvio Berlusconi, the former premier, called for a recount and won a blocking minority in the Senate.

The stalemate means the big questions surrounding how Italy deals with its debts won't be resolved any time soon - triggering a huge amount of sell offs by traders as they try to shift risks off their balance sheet.

And it's not just the FTSE that's falling - the US's S&P 500 and Japan's Nikkei also suffered from mass sell offs.

But is it as bad as it looks for the FTSE and the UK?

Economists were split this morning as to how serious Tuesday's sell off was in the long term - many said the recent sustained rally that the FTSE has enjoyed had perhaps gone on longer than was first anticipated, meaning the drop of shares was simply a market correction.

Others were more concerned however - Barclays, HSBC, Lloyds and RBS shares were down sharply on Tuesday following a recent rally in banking stocks. This particular sector sell off is driven by something called contagion risk - a spectre which hasn't reared its head for a few months, but is the theory that economic collapses will lead to others in a domino fashion.

"We are back in a situation where necessary and important austerity measures are being rejected by yet another Club-Med nation," said Mike van Dulken, head of research at Accendo Markets.

"Remember that the European Central Bank's recent breakdown of its holdings showed Italian bonds as its biggest holding of Eurozone debt (€99bn). This is likely contributing to the single currency's persistent weakness versus the US dollar.

"If Italy's second election sees austerity rejected radically enough, and markets refuse to fund the country's debt requirements at sustainable costs (yields rise on reduced trust in ability to be repaid if not sticking to deficit rules and reforms), we could be heading for the outside lane of route one back to square one in the Eurozone sovereign debt crisis. Non Bene."

Tristan Cooper, sovereign debt analyst at Fidelity Worldwide Investment, agreed that European policy makers are now very concerned about averting a potential market meltdown because "Italy is too big to save". He also noted that the situation is different to when Greece was undergoing its painful debt negotiations, as a new Italian government when it is formed is more likely to be unstable and ineffective than unorthodox and radical.

Particularly worrying was the suggestion that Italy's financial regulator was considering putting a ban on shorting Italian stocks. As noted by Steve Collins, global head of dealing at London & Capital Asset Management:

But there are those who believe a stalemate isn't all bad, as it means Mario Monti's existing austerity measures will remain in place for now.

"Italy merely needs to hold the line," Holger Schmieding, Berenberg Bank AG' chief economist, wrote in a note to clients.

"We maintain our view that, in purely economic and fiscal terms, a political stalemate without major new reforms would be unfortunate but not a disaster."