European Rally Loses Steam

The rally in European equities stuttered for a second day on Tuesday, in sight of 13-month highs, with investors concerned about the strings that Germany may attach to the eu r o zone bailout fund and the chance the U.S. may not deliver widely awaited stimulus.

The German Constitutional Court is expected to approve the European Stability Mechanism on Wednesday. But it may impose conditions, leading to a delay in the European Central Bank's new bond-buying programme, which investors have cheered as a step to bring down sovereign borrowing costs and tackle the euro zone crisis.

Uncertainty also hangs over Thursday's U.S. Federal Reserve policy decision. Markets are priced for fresh stimulus while economists give only a 60 percent chance of a third round of quantitative easing coming as soon as this week.

"There is a lot of questions in the very short term," said Benoit Peloille, equities strategist at Natixis.

"The market increased quite a lot over the last week so we need something new to have a second breath for this rebound, and we could have this after the result of the (German) court and after the Fed action."

The FTSEurofirst 300 was down 0.4 percent at 1,099.38 points by 1014 GMT, retreating from a 13-month high of 1,113.22 set at the end of last week.

The benchmark Spanish index dropped 1.0 percent, while the Italian bourse was off 0.9 percent on concerns that any conditions imposed by the German court may discourage those countries from asking the ECB for help.

"Of course they (the court) will say yes, but they will probably say yes with a 'but', maybe something like that Germans can oversee Spanish and Italian budgets," said Peter Garnry, equities strategist at Saxo Bank.

"If that becomes conditionality from the Germans, it is likely that the Spanish government will delay asking for help until they are really backed into the wall ... Then you (will) have this postponement in the euro zone and you could possibly see bond yields go higher, so that's a key risk."

A Dutch general election on Wednesday, posed another event risk, with voters divided over the demands for massive bailouts for Europe's so-called budget sinners, and for austerity measures at home that chip away at their cherished welfare benefits.

The corporate news flow also fed in to the more cautious investor mood, with luxury goods companies hurt by a profit warning from Burberry.

Shares in the British company -- famed for raincoats in distinctive camel, red and black check pattern -- fell 18.6 percent. Swatch, Richemont and LVMH each shed 4.4 to 5.7 percent

"We have been fans of Burberry, and remain of the view that the strategy, luxury positioning and management team should lead to long-term sector outperformance. Today's statement does, however, imply a significant slowdown and Burberry is not immune from wider macro-economic turbulence," Investec said in a note.


Given the accumulation of event risks, strategists advised investors to take protection via the options market, especially given the relatively low implied volatility.

Implied volatility on the EuroSTOXX 50 has picked up from last week's one-month lows, but is still some 10 percent lower than it was before the ECB unveiled the details of its bond buying on Sept. 6.

"Volatility has collapsed quite sharply, particularly after the ECB announcement, so vol is pretty cheap now. The Dax is still one of the indexes that has performed the best in Europe so out-of-the-money (put) options on the Dax look fairly compelling," said Kokou Agbo-Bloua, derivatives strategist at BNP Paribas.

Put options allow investors to sell the underlying asset - in this case the German Dax - at a pre-set price in the future and are thus used by investors to protect portfolios from a possible market fall or to simply bet on the downside.

Investors snapped up nearly two September 2012 put options for every call -- which allows exposure to market gains -- on the Dax on Monday, according to Eurex exchange.