Euro-Area Hedging Costs Climb on Russia, Economy Concern

Options traders are turning increasingly skeptical on euro-area equities as they assess military tension between Russia and Ukraine and concern over deflation in the 18-nation trading bloc.

The cost of protecting against swings in euro-zone stocks jumped 52 percent from the Euro Stoxx 50 Index’s almost six-year high in June through Aug. 8. The gauge of regional equities tumbled 9.3 percent during that time, with Germany’s DAX Index entering a correction. Swiss and U.K. equities each declined less than 5.5 percent from their peaks, making options on the two national benchmark gauges the cheapest in more than a year relative to their neighbors in the euro area.

Investors turned bearish amid Russia military drills along its border with Ukraine and sanctions against the European Union. Two members of the euro area, Germany and the Netherlands, are Russia’s biggest trade partners after China. The currency zone’s persistent low inflation may also prompt investors to buy U.K. and Swiss equities instead, according to LGT Bank Schweiz AG’s Alessandro Fezzi.

“I see more risks for the euro area, particularly the region’s engine, Germany, regarding further escalation of the situation with Russia, than for the U.K. and Switzerland,” said Fezzi, a senior market analyst at LGT Bank Schweiz in Zurich. “Swiss stocks are seen once more as a safe haven. And with the U.K., there is more chance of outperformance, even with the risk of a stronger pound.”

Ukraine Conflict

The Euro Stoxx 50 completed its first back-to-back weekly retreats since March. The DAX has fallen more than 10 percent from its July all-time high, meeting the definition of a correction. European Central Bank President Mario Draghi warned last week that the conflict in Ukraine will hurt the euro area more than other economies.

Inflation in the region dropped to 0.4 percent last month, the slowest pace in almost five years and less than a quarter of the ECB’s goal of just under 2 percent. The figure has stayed below the 2 percent mark every month since February 2013.

Recent data from Italy and Germany has disappointed economists, pointing to weakening activity in the euro area. Italy, the zone’s third-biggest economy, unexpectedly swung back into recession last quarter, while German factory orders contracted in June.

Future Volatility

From a low in June, implied volatility -- a measure of the cost of protecting against price swings -- has surged 55 percent for two-month contracts on the Euro Stoxx 50. The gauge of expected volatility for Swiss and U.K. equities fell to the lowest since April 2013 relative to euro-area stocks, according to data compiled by Bloomberg. The ratio for the Swiss Market Index set a low on Aug. 1 and the FTSE 100 Index on July 28.

The selloff in euro-area equities will prove temporary as investors turn their focus to company earnings later in the year, according to Kevin Lilley, who helps manage 17 billion pounds ($29 billion) as head of European equities at Old Mutual Global Investors U.K. in London.

“People are de-risking their portfolios before going on holidays, especially given the rise in geopolitical tensions,” said Lilley. “Once everyone’s back in September, there will be more focus on the European recovery through the end of the year. I’m playing the recovery in Europe.”

Earnings Estimates

Earnings for euro-area stocks will probably rise 11 percent this year, according to data compiled by Bloomberg. That compares with an estimated increase of 2.2 percent for FTSE 100 companies and 14 percent for the SMI.

Eight of the 10 most-owned options on the Euro Stoxx 50 were bearish at the end of last week, data compiled by Bloomberg show. Contracts betting the index will decline 10 percent to 2,700 by Dec. 19 had the biggest ownership.

The VStoxx Index, which measures the cost of expected volatility on the Euro Stoxx 50, climbed 2.1 percent to 21.24 on Aug. 8, its highest level since March 17. It declined 8.5 percent to 19.43 at the close in London.

“The euro-zone economic outlook is poor and deflation pressures are very high, so investors need to be cautious,” said Jacques Porta, who helps oversee $780 million at Ofi Gestion Privee in Paris. “The tensions in Ukraine do not help. While the Swiss economy is also dependent on the euro zone, its stocks have become safe havens as they usually do when we have stress in the markets. The U.K. economy is less dependent on euro zone, so its market is safer.”

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