Investors hedge against a European stock market downturn

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Cautious investors are snapping up derivatives that would protect them if this year’s rally in European stocks crumbles, in a sign of mounting concerns that slowing economic growth will weigh on markets sitting close to record highs.

Traders have been buying an increasing number of put options, which provide insurance against a slide in prices, relative to calls, which pay out if the market rises. In so doing, they betray an “underlying nervousness” about European stocks despite their recent run, said analysts at Bank of America.

The ratio of puts to calls tied to the blue-chip Euro Stoxx 50 benchmark has risen to its highest level in BofA data stretching back a decade.

The index — which includes luxury goods group LVMH, chip equipment maker ASML and industrial conglomerate Siemens — has risen 14 per cent since January to its highest level since 2007. The eurozone economy sank into a mild technical recession in June after two consecutive quarters of contraction.

“Fundamentally, we’re still in a place where [Europe’s] growth outlook isn’t amazing,” said Abhinandan Deb​​​, head of global cross asset quant investment strategy at BofA Global Research. “People are uncomfortably long [Europe]. They’re long because they need to participate, but the fundamental conviction isn’t there. No one wants to chase this market so close to its high.”

Alexandru Bohotin, head of European index options trading at Optiver in Amsterdam, said he had seen more demand for “downside protection” from investors in European stocks, particularly as investors have begun to reallocate to equities after being underweight most of the year. “They’re protecting their portfolios through buying puts, which is what’s driving up metrics like put/call ratios,” said Bohotin.

Other investors point out that a recent slowdown in activity across Europe’s hitherto resilient services sector also bodes poorly for local stock markets.

S&P Global’s eurozone services purchasing managers’ index, a measure of activity in services, fell for a second month running in June to 52, indicating continued expansion, albeit at the slowest pace since January. 

The slump in service sector momentum may soon begin to weigh on European equities, which have pushed higher so far this year — defying many investors’ expectations — even though the European Central Bank has ratcheted up interest rates at unprecedented speed to combat inflation. 

Services account for roughly 70 per cent of economic activity in the euro area with the services PMI viewed as a strong leading indicator of stock price performance because of its high correlation with services activity.

“The whole bounceback of share prices in Europe after last winter was due to this rebound in services. People thought and still think that the economy remains resilient,” said Tomasz Wieladek, chief European economist at T Rowe Price. 

However, “[services PMI] will probably go down significantly as part of the natural monetary policy tightening cycle and that’s something that markets are not prepared for,” he said, adding that the euro area services PMI has been “highly correlated” with European share price moves over the past three years.