New Italy election is worst-case scenario -investor survey
* Morgan Stanley says ECB backstop supporting Italy
* But most investors don't see ECB stepping in
* Say Italy political, economic risk underestimated
By Lisa Jucca
MILAN, March 15 (Reuters) - Financial investors would prefer Italy avoided new elections, concerned they would just postpone economic reform and bring little hope of resolving a parliamentary deadlock, a survey by U.S. bank Morgan Stanley showed on Friday.
Only significant funding problems and a much deeper recession would reignite the sort of fear that pushed Italy's 10-year bond yields above 6.5 percent in July, according to the survey of 317 market participants carried out this week.
But two thirds of those polled considered the prospect of Italy holding new elections after being unable to form a government as the worst-case scenario politically.
"A return to the polls would risk prolonging uncertainty," Morgan Stanley said in its analysis of the survey, which compiles the responses of fund managers, banks, hedge funds, insurers and pension funds.
"An unresolved political situation cold postpone a resumption of the reform path or dilute it further."
A national election on Feb. 24-25 resulted in a hung parliament and Italy's main parties have been unable to find a way out of the impasse.
However, debt markets have so far taken the gridlock in their stride, largely thanks to the European Central Bank's pledge to buy potentially unlimited amounts of bonds from euro zone countries in trouble that ask for help.
"The perceived ECB backstop is of course a major factor behind relatively well-behaved markets," Morgan Stanley said. "Conversely, previous political events, such as government crises, have exerted a substantial influence on Italian financial markets over the past several decades."
Italian bond prices are also supported by the fact that two-thirds of the country's debt is now in domestic or ECB hands, a stabilising factor.
But if the economy, which the Bank of Italy says will contract by 1 percent in 2013, were to slow down much further, markets could start to take fright.
"We remain concerned that the uncertainty may continue to affect the economy and ownership of Italian shares," Morgan Stanley, which is underweight in Italian banks, said.
According to the poll, investors overall currently assign a less than 25 percent probability to the ECB having to enact its bond-buying programme for Italy. Foreign investors, who represented 70 percent of those polled, have a more bearish outlook, seeing up to a 50 percent chance.
For foreign players, Spanish debt is the asset most likely to suffer from a new Italian debt crisis, followed by European equities, Portuguese assets and the euro, with U.S. Treasuries and German Bunds seen as safe havens.
The survey showed many believed markets in general were underestimating the potential risks from protracted political instability and the weakness of Italy's economy.
On the other hand, they would be positively surprised if the centre-left Democratic Party were to appoint Matteo Renzi, the young mayor of Florence, as its leader in place of current party chief Pier Luigi Bersani.
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