How to profit as Italy heads to the polls

It's safe to say that there aren't many politicians with the staying power of Silvio Berlusconi. Less than four months ago, he was sentenced to a year in jail for tax fraud. And he still faces other criminal charges. Yet the polls still suggest that there's an astonishingly good chance thatthe former prime minister will actually win next week's election in Italy.

This is clearly amusing in its own way given how many people breathed a sigh of relief when it looked like jail might be the end of 'bunga bunga Berlusconi' as a political force. But it also comes with some very unfunny implications.

Everyone knows that Berlusconi isn't that into either the European Union or into the austerity apparently required to keep it together. So, as his poll ratings are surging, so are Italian bond yields: they have hit levels not seen since the end of last year. That's not a good thing.

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The end of Monti's dreams

Back in November 2011, it looked as if Italy with its huge deficits and clear unwillingness to reform - was on its way out of the euro. To make it possible to 'save' Italy, Brussels made it clear that Berlusconi had to go. He did. And in his place came the technocrat and Brussels man Mario Monti, a former commissioner.

The idea was that his non-partisan status and close relationship with Brussels would help him pass reforms, cut spending and stop Italy being the catalyst for European collapse.

This was undemocratic stuff (which is also not a good thing). So, at the time, Monti promised that he was nothing but a concerned caretaker one who had no intention of running for re-election. In reality, there were hopes that the major parties would allow him to stay on asprime ministerwithout having to face voters.

Things got off to an adequate start. There was much PR put out about the basic strength of Italy (and it is true by the way, that the average Italian household is less stretched than, say, the average Spanish household).

And there was some small success in pushing business and labour-market reform. However, along with reform came tax rises and rising unemployment. That didn't go down well at all. The result? A new movement - 'Five Star' - surged in the polls demanding an end to austerity. It became clear that Mr Monti was not going to be re-elected by default.

That was clearly disappointing for him. Once you have had a taste of power, it is tough to give it up. So at the end of last year, Monti changed his mind and decided to run for office as part of a group of parties called 'With Monti in Italy'.

It isn't going that well. Polls currently show their support running at around 13% in the polls. That puts them fourth. And the candidates in first, second and third place? They are all anti-austerity.

Italy has a long way to go

The obvious take away from this is that, even if Berlusconi himself doesn't win, the next government isn't going to be doing what Brussels wants it to. That sounds bad but the truth is that even if a new government wanted to stick with the status quo, it's hard to see how it could. Without real inflation or external devaluation (a falling currency of the kind the UK is so used to for example) to speed the process up, the pace of change is simply too slow.

Take wages. To be able to compete with Germany, Italy needs to cut its unit labour costs. However, relying on firms to directly cut wages has had little effect. While Italian wages are now coming down, they are only doing so slowly.

Italy is still less competitive than Greece, Ireland and Spain so much so that Capital Economics reckons wages will need to fall by a further 15% to 20% for the crisis to be of much use to Italy's corporate sector.

The big choice ahead

The key point is that the next Italian government is going to be neither willing or able to dabble in austerity and reform while waiting for things to resolve themselves. So what's going to happen?

You might think the best thing would be for Italy to get on and leave the euro. A new lira would fall in value and that would cut real wages via imported inflation. Italy would be competitive, exports would rise, debt would fall. Job done.

If only it were so easy. After all, were this simply a question of economics, the euro would be long dead. The more likely solution is another attempt to smooth over the cracks with more quantitative easing (QE) from Brussels.

We have long predicted that, when push comes to shove (as it often seems to these days), the European Central Bank(ECB) is willing to do anything to keep the single currency together. So far, that's been the correct assumption to make.

In any case, world events are also forcing MarioDraghi's hand. Japan's new inflation target, the Fed's open-ended QE and the decision to appoint Mark Carney as head of the Bank of England, risks leaving Brussels with an overvalued euro - Robert Jukes, global strategist at Collins Stewart Wealth Management, thinks that the euro is overpriced against the dollar by not far off 20%.

This means that unless the ECB wants exports to collapse (something Germany's many manufacturers clearly don't fancy), it is going to have to throw itself into the currency wars.

So how should you play this? QE is good for equities (albeit in a bad way) and falling currencies are good for equities too. So the best way is probably the usual way buy into Europe's stock markets. Which ones? We've been suggesting Italy for a while now where Andrew Goldberg of JP Morgan reckons that Italian shares are still 65% below their 2007 peak.

One way to tap into the Italian market is to buy an Italian ETF, through iShares FTSE MIB (UK: IMIB). Another is to buy shares in high-quality companies like Pirelli (MILAN:PC), which trades at a price/eanings (p/e) of 8.4.