An end to la dolce vita?

Italy’s passage of belt-tightening measures Friday, coupled with its impending change of leadership, calmed immediate fears about Europe’s debt crisis, but investors should brace for more eurozone turmoil in the weeks and months ahead.

“The problems facing Europe didn’t happen overnight, and they won’t be solved overnight,” said James Sarni, managing principal at Payden & Rygel, which manages $60 billion in assets.

Citing last week’s near-collapse of Italy’s sovereign-debt market, which sparked a 24-hour global sell-off Wednesday of both stocks and bonds, Mr. Sarni predicted that for at least the next 18 months, investors should brace for more of the extreme risk-on and risk-off volatility that has characterized markets of late.

“It will literally be like a light switch,” he said. “And when it is off, everything does poorly, except for maybe U.S. Treasuries and German government bonds.”

While European leaders scramble to put together some patchwork solutions to head off a debt and banking crisis, financial advisers brace for more tumult.

“This is just another plot twist in the “War and Peace’-type novel that started a few years ago,” said Matthew Lloyd, chief investment strategist at Advisors Asset Management LLC, a $7.2 billion advisory firm.

Highlighting the weaknesses of the European Central Bank, which unlike the U.S. Federal Reserve system doesn’t have the tools to bail out its debt-laden members easily, he compared the looming problems to a jack-in-the-box toy.

“You know what’s going to happen; you just don’t know when it’s going to happen,” Mr. Lloyd said. “Whether it is Greece, Portugal, Spain or Italy, the common denominator is the kind of unionization that forces up spending, and with no leader in the European Union, the model does not hold up under stress.”

The eurozone’s debt problems have been a hot topic for more than a year, but the heat was turned up last week when the attention turned to Italy, the third-largest economy in Europe and the world’s third-largest bond market.

The debt issues facing Italy, which forced the resignation of Prime Minister Silvio Berlusconi, managed to overshadow the potentially more serious budget issues facing Greece, which is a much smaller economy.

“Greece? Who cares about Greece at this point? That debt is trading at 50 cents on the dollar, so they’ve already defaulted,” said Art Steinmetz, chief investment officer of OppenheimerFunds Inc.

“Fact is, the fundamental design flaws in Europe have come home to roost,” he said. “The markets keep yearning for a final answer and there just isn’t one, because they just keep wrapping duct tape and coat hangers around that creaky structure.”

A big part of what makes the eurozone debt crisis so difficult to handicap is that it has become increasingly intertwined with politics.

“Global risk, not market fundamentals, have been driving markets for the past three months, and for the past week, that risk has been really political and nonfinancial in nature,” said Doug Coté, chief market strategist at ING Investment Management.

UNFORTUNATE BLUEPRINT

Along those lines, Greece is seen by some as the unfortunate blueprint for what could happen in other European nations, including Italy.

“If the politicians succumb to the population’s will, and Greece defaults on its debt, the ultimate outcome will be a run on the banks,” said George Feiger, chief executive at Contango Capital Advisors, a $3.3 billion trust company and advisory firm.

As he sees it, a Greek default could move the country off the euro and onto its own, very weak currency.

“As soon as the people in Greece see that the country has its own currency, you’ll see a run on the banks and an immediate collapse of the Greek banking system,” Mr. Feiger said. “We’re looking at the beginning of the biggest bank run in history, and there’s nothing in the European Union structure to prevent the situation.”

But the political influence on the global financial markets isn’t limited to Europe, according to Mr. Sarni.

“It’s difficult to quantify how much the recent market volatility is the result of Europe, and how much is from our own political challenges,” he said.

Mr. Sarni concurs that Italy was probably the catalyst that drove U.S. stocks down nearly 4% on Wednesday.

But he pointed to the strong rebound Thursday, “when nothing really changed in Italy.”

Catalysts work because of a “complete lack of anyone willing to make a long-term commitment to the markets,” Mr. Sarni said.

“Businesses are worried about taxes and regulations, and individual investors are worried about interest rates and geopolitical issues,” he said. “As long as that is the case, we will continue to have this kind of volatility.”

Email Jeff Benjamin at [email protected]