by Russ Koes­terich, iShares

I’d long planned to travel to Milan this week to meet with Ital­ian investors, but the fact that my trip coin­cided with polit­i­cal tur­moil in Italy tuned out to be a lucky coin­ci­dence. My trip has allowed me to develop a much clearer pic­ture of what Italy’s polit­i­cal tur­moil means for the mar­kets and why the next 72 hours are critical.

There is a con­sen­sus among investors I spoke with and — judg­ing by news reports — among investors in gen­eral that last night’s appoint­ment of Mario Monti to the posi­tion of sen­a­tor for life is an impor­tant pre­cur­sor to a deal for a new Ital­ian gov­ern­ment.

Based on my conversations, investors believe that the most likely deal sce­nario is that Berlus­coni will finally bow to polit­i­cal pres­sure this week­end and resign, and Monti will be appointed prime min­is­ter to head a coali­tion gov­ern­ment. Under this sce­nario, an immi­nent elec­tion would be avoided.

Why Monti for prime min­is­ter? He’s a respected tech­no­crat, and Ital­ian investors believe he can lead a care­taker coali­tion gov­ern­ment that will imple­ment the nec­es­sary reforms. One senior investor explained to me that by mak­ing him a sen­a­tor for life, he is now pro­hib­ited from form­ing his own polit­i­cal party, a sce­nario that derailed another tech­no­crat gov­ern­ment in the mid 1990s.

Here’s the Best-Case Sce­nario: Assum­ing the most likely sce­nario hap­pens – Berlus­coni resigns and Monti becomes prime min­is­ter — I would expect global equi­ties and other risky assets to stage a strong rally. This sce­nario would be a major, pos­i­tive step toward imple­ment­ing nec­es­sary reforms in Italy. Plus, once Italy starts to move down a path of reform, investors expect that the Euro­pean Cen­tral Bank will be more will­ing to resume its bond pur­chase program.

Here’s the Worst-Case Sce­nario: The mar­ket impli­ca­tions if Berlus­coni stays on and there is an elec­tion in early 2012 are far from cheery. This sce­nario would likely lead to a col­lapse in the Ital­ian bond mar­ket, a strong like­li­hood of a severe Euro­pean reces­sion and a ris­ing like­li­hood that the euro cur­rency could break up. In addi­tion, the risks of a bank­ing cri­sis would also rise. Under this sce­nario, investors would want to con­sider low­er­ing their allo­ca­tion to risky assets.

The next 72 hours will be crit­i­cal. Most Ital­ians I spoke with thought an announce­ment about a gov­ern­ment deal is likely over the com­ing weekend.

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