The prospect of a long period of political uncertainty following elections in Italy, the euro zone’s third-largest economy, has shattered months of uneasy calm in European financial markets and demonstrated that the currency union remains prey to shocks.

Italy’s protest vote against the Eurocrats has wrenched market attention away from the hunt for yield and back onto political risk. The social disaffection caused by youth unemployment has been strikingly reflected by the surge of the Five Star movement.

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.

Austerity-first solution
The elections have also emphasised that the most powerful opposition to the euro-zone crisis managers’ austerity-first solution to the bloc’s financial crisis could come from the ballot box. Three polls last year—a referendum in Ireland on new fiscal rules and elections in the Netherlands and Greece—went in favour of the euro’s political masters, in Greece’s case only just. However, in Italy, the euro zone seems to have run out of luck in a vote interpreted as a rejection both of the country’s traditional political class and of the austerity many Italians see as being imposed on them by Brussels and Berlin.

Financial-market tranquillity
The return of growth in Southern Europe is officially projected to be reached in the next 12-18 months, but may have been further postponed due to recent uncertainty. But there was no sign of any rethink: euro-zone governments and the European Commission have urged Italy to stick to the path of economic overhauls and budget stringency. The election has challenged the optimism beginning to emerge among politicians that the crisis was over, which had been encouraged by the financial-market tranquillity following the promise from European Central Bank President Mario Draghi in July to “do whatever it takes” to save the euro.

A grand coalition
We can now expect weeks of hiatus in the Italian political system as political leaders discuss whether they can form a grand coalition that can govern the country seems a certainty. Nothing formal can happen until March 15, at the earliest, when Parliament is formally convened. By May 15, President Giorgio Napolitano’s mandate will expire and a new president must be elected. An early decision to call new elections seems unlikely: to do so in an apparent effort to get the “right result” for the EU risks a further backlash among voters.

Fiscal discipline 
The political will to preserve Eurozone stability has been proven in Greece. A new government in Italy, when it is eventually formed, is more likely to be unstable and ineffective than unorthodox and radical. Fiscal discipline is likely to be broadly preserved even if serious structural reforms are now off the agenda. Hence, the negative market reaction to events in Italy may provide an opportunity to buy into the periphery, albeit at significantly higher yields. It will be important to keep an eye on the rating agencies, who could well jangle nerves with another downgrade if policy uncertainty in Italy persists.