UK and European markets took a dive on Tuesday after it emerged that there was no clear winner from the Italian elections. Italian voters were torn between three main parties, which raises the prospect of a second election in the next few months.
European policy makers will be very concerned to avert a potential market meltdown given that Italy is too big to save
"The Italian electorate’s indecision has provided a fresh dollop of political risk to the recently calmed financial-turned-eurozone-sovereign-debt-crisis saga," explained Mike van Dulken, head of research at Accendo Markets.
In London, the benchmark FTSE 100 reacted by falling 85 points, or 1.3%, to close at 6,270. The mid-cap FTSE 250 index dropped by 150 points, or 1.1%, to close at 13,536.
"Italian economic fundamentals are fragile and the recession still deep. At best, the political impasse in Italy will push back the market's expectation of a recovery there. At worst, the contraction could deepen as consumer and business confidence cowers under an extended period of political uncertainty," said Tristan Cooper, sovereign debt analyst at Fidelity Worldwide Investment.
"European policy makers will be very concerned to avert a potential market meltdown given that Italy is too big to save, " said Cooper. "The European Central Bank (ECB) is the only institution really capable of putting out fires. An ECB rate cut next week now looks likely and Mario Draghi will stress that the OMT bond-buying program is there to assist if needed. Yet the OMT is an untested tool that can only be expected to kick in at high levels of market stress. It also requires conditionality, which will be difficult to negotiate with a rudderless Italian state."
UK Banking Shares Suffer
Shares in large UK banks led the way down on the FTSE 100, with 
Barclays (BARC) and the Royal Bank of Scotland (RBS) each losing 4.7% and 4.3%, respectively.
"The UK’s bank shares are down sharply ... on the prospect of a period of political uncertainty in Italy following the inconclusive election and rejection of reforms ... The news has revived something which had taken a back seat for a while - contagion risk - after a period of relative stability, helped by accommodative stances from major central banks," said van Dulken.
"Remember that the ECB’s recent breakdown of its holdings showed Italian bonds as its biggest holding of Eurozone debt (€99 billion). This is likely contributing to the single currency’s persistent weakness vs. the US dollar, combined with natural safe-haven flow to greenback. The situation is likely similar at Italian banks [since] domestic banks tend to hold lots of national debt, which affects how other European banks view them and likely Spanish peers too ... This also even affects how UK banks view each other with the unknown of each one’s exposure to Italy (and Spain) given the extensive interconnectedness of the sector," said van Dulken.
US Markets Mixed
In the US, stocks pared earlier gains and were mixed in the afternoon as investors considered the comments that Federal Reserve chairman Ben Bernanke made to Congress. As part of a semi-annual appearance in front of Congress, Bernanke reiterated that the Fed will continue its bond-buying program, lauding the benefits of the asset purchases. He also said he hopes Congress can reach an agreement on spending and budget cuts amid the looming sequestration.
This article was written with notes from Morningstar's Kevin O'Shaughnessy.
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