How you can profit from the panic over Italy

After such an exuberant few months, markets have been looking for an excuse to correct.

Yesterday, they got one. The Dow fell 200-odd points, and the euro plunged while the yen soared - a classic risk-off' move. This morning, Japan's Nikkei index has dropped by more than 2%. The Vix index Wall Street's fear gauge' jumped by more than 30%.

It's all Italy's fault. The voters didn't do what markets had hoped they would. The dust is still clearing on the results, but it's possible that Italy might even need to go to the polls again. That's uncomfortably close to a Greek-style result.

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Time to sell Europe then?

Not at all. In fact, it's a good time to get ready to buy some more

Here's why we might face a second Italian election

I have to admit, I find watching other nations' politics pretty tedious. Monitoring the hijinks of our own politicians is depressing enough without having to stay abreast of the antics of another lot who you don't even get to vote for.

So I'll keep this short. Until this election, Mario Monti was running Italy. He was parachuted into the job by the European Union when former prime minister Silvio Berlusconi resigned in 2011.

Monti stands for austerity. He was trying to sort out Italy's finances and its structural problems. He made some progress, and markets liked him because he kept a lid on Italy's antics at a time when Greece and Spain were hogging headlines. But voters don't like austerity, particularly when it's imposed by someone who hasn't even been elected by them. So Monti was always unlikely to win a lot of support.

That left three political forces: a centre-left coalition, led by Pier Luigi Bersani; a centre-right coalition, led by the comeback king, Berlusconi; and the Five Star Movement, a protest party led by a comedian (I'll leave you to insert your own LibDem joke here).

Complacent investors had hoped for the centre-left coalition to be elected. And early polls suggested that's what they would get. Markets cheered, and the euro stayed strong.

But the actual results sprung a nasty surprise. In short, no party won. The centre-left looks like it might control the lower house, but the upper house looks split between Bersani and Berlusconi, with the Five Star Movement winning a sizeable number of seats. Even if a coalition can be patched together, it is unlikely to last.

So as sovereign debt analyst Nicholas Spiro told the FT: "This looks like a recipe for total gridlock financial markets are facing the worst of both worlds in Italy: a full-blown political crisis in the eurozone's third largest economy and a severe setback for the liberal economic agenda championed by Mr Monti."

Stick with your European stocks

Sounds nasty. And you only need to look at a chart of the euro against the yen, or the dollar, to see the impact. The Italian stock market has tanked too. And the uncertainty might well continue - if Italy ends up needing another election, markets will be on tenterhooks until it's over.

So how can we be suggesting that you stick with your European stocks?

Here's why: the chaos in Italy takes the European Central Bank (ECB) one step closer to doing full-blown quantitative easing (QE) and printing money to bail the eurozone out of its depression. It won't have a choice.

Italy might be acting out a Greece-style scenario, but it's nothing like that country in terms of economic clout. There is no question of pretending that Italy can leave the euro; it's the third-largest economy in the region. Germany can't call Italy's bluff, as it tried to with Greece. If Italy leaves the euro, you can kiss the euro goodbye.

In any case, just like the Greeks, the Italians aren't desperate to leave the euro. They might not be keen on austerity funnily enough, no one seems that keen on higher taxes, lower wages, and fewer benefits but as with Greece, this was an anti-austerity vote, not an anti-euro vote. The preferred route for Italy would be a weaker euro, not a return to the lira.

So what'll happen? If markets panic and continue to drive up Italian bond yields, and everyone gets themselves into a tizzy, ECB head Mario Draghi will have to step in and act on his promise to do "whatever it takes." As my colleague Matthew Partridge pointed out a few days ago, before the Italian vote, that'll involve QE, one way or the other.

Now let's make something clear. We don't think the euro is sustainable in the long term, for reasons that should by now be obvious. We also don't think money printing is an especially good idea. It allows governments to put off making hard decisions until it's too late something we're already seeing happen in Britain.

But if there's one thing we've learned over the past four years or so, it's that printing money boosts asset prices. We've seen it in the US, the UK, and recently even Japan. So if Europe is going to print money, you should probably be in European stocks.

If you don't feel like buying now, don't worry I don't blame you. You may get better opportunities in the weeks ahead as the hysteria builds. Or perhaps you won't - markets may have bought so heavily into the Draghi put' by now that this will just be a blip.

That's why I'd be inclined to drip-feed money in, rather than trying to pick a precise moment of maximum despair. In any case, this makes no difference to our case for buying Europe it just provides another potential buying opportunity.

For more on why Europe is likely to launch QE later this year, read James Ferguson's cover story in the current issue of MoneyWeek magazine. If you're not already a subscriber, subscribe to MoneyWeek magazine.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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