* STOXX 600 up almost one percent; Auto shares leap 2.2 percent
* BMW, Volkswagen, Daimler up 2-3 percent as US-Mexico reach NAFTA deal
* German shares gain 1.2 percent to touch 2-1/2 week highs
* Metro, Lundin Petroleum other big gainers
* German-listed Tesla shares fall as Musk drops bid to go private (Adds closing prices, detail on NAFTA)
By Helen Reid
LONDON, Aug 27 (Reuters) - European auto shares surged more than 2 percent on Monday as news of a U.S.-Mexico agreement on NAFTA added to the bullish sentiment generated by U.S. Federal Reserve chairman Jerome Powell's market-friendly speech.
A British public holiday thinned trading volumes across the region but European markets opened broadly firmer after Powell late last week affirmed the U.S. central bank's current gradual pace of rate hikes. The comments sent Wall Street to record highs on Friday.
The pan-European STOXX 600 closed 0.5 percent higher, as the U.S. S&P500 and Nasdaq added to gains, after a Mexican source said the two countries had reached agreement in the North American Free Trade Agreement.
U.S. President Donald Trump had suggested earlier on Monday that the United States and Mexico were close to a "big deal" .
The euro stocks index as well as Germany's DAX touched 2-1/2-week highs, with the former closing 0.9 percent higher and the latter riding 1.2 percent higher on the back of the auto rally.
Car shares enjoyed their best day in a month with gains of 2.2 percent. German carmakers, especially, rely on smooth trade between Mexico and the U.S. to sell vehicles made in Mexican plants into the U.S. market. "The biggest risks the market were discounting were trade wars, so any reduction in trade war risk such as NAFTA talks or even Trump trying to find bilateral deals, has pushed U.S. shares to new records and will support markets," said Angelo Meda, head of equities and portfolio manager at Banor SIM in Milan.
BMW, Volkswagen, Porsche and Daimler rose 2.5 to 3.0 percent.
However, also in auto news, the Germany-listed shares of U.S. electric carmaker Tesla fell almost 4 percent on the Tradegate exchange. Tesla's U.S. shares dipped around 3.3 percent after Chief Executive Elon Musk called off a bid to take the company private.
Outside trade-driven moves, Metro shares surged 13.3 percent after Ceconomy announced it may join family-owned Haniel in selling a stake in the German retailer to an investor group led by Czech billionaire Daniel Kretinsky.
Lundin Petroleum shares climbed 3.5 percent after Norway's Equinor increased its resource estimate for the Johan Sverdrup oilfield, in which Lundin has a 22.6 percent stake.
Equinor, which has a 40 percent stake in the field, gained 1.2 percent.
The easing of trade tensions should be good news for the STOXX 600 which is down 1.2 percent year-to-date due to political developments in Italy and Turkey. There was also good news on the data front on Monday, with a robust German business sentiment survey adding to signs of an improving euro zone outlook.
But while companies have delivered 10.9 percent year-on-year growth in second-quarter earnings, valuations are low given risks such as Italy's budget, which will be thrashed out in September.
"Europe is one of the cheapest markets in the world, there is for sure a risk premium implied in the valuation," said Banor SIM's Meda.
Italy's FTSE MIB underperformed rivals, rising just 0.3 percent.
"The only cloud on the horizon is Italy," Meda added. "The feeling I have is nobody has any will to take any risk in the next couple of weeks before we get more clarity on the budget."
Reporting by Helen Reid; Additional reporting by Sujata Rao; Editing by Andrew Bolton