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* Credit market less optimistic than equity on financials
* Strong U.S. earnings distract from Europe-specific risks
* Valuations not attractive, even in euro zone periphery
By Alistair Smout
LONDON, July 24 (Reuters) - European bank shares drivenhigher by strong earnings from U.S. lenders may be set for afall as their own results season begins, with credit marketsreflecting wariness about risks glossed over by equityinvestors.
Forecast-beating earnings from Bank of America andCitigroup lifted shares in European banks last week.
However, the market for insurance against banks defaultingon their loans shows more caution over the European sector,which is still struggling with bad debts in the euro zoneperiphery and regulatory costs.
Thomson Reuters StarMine data shows the second-quarterearnings season is set to disappoint, relative to that in theUnited States. Early reports have not seen much of a bounce inthe shares of those European banks that beat expectations.
"The credit is a lot more cautious than equity... andEuropean financials are a major culprit from the equitystandpoint: they're running ahead of the underlying risks,"Chris Parkinson, head of research at Christopher Street Capital,part of GFI Group, said.
"The equity market, having looked at the numbers coming fromthe United States, has seen buying of banks and financials moregenerally on the back of that, and it's ignoring thelonger-standing underlying issues that are affecting Europe."
An index of European bank stocks rose 3.3 percentlast week, buoyed by earnings beats by U.S. peers, but an indexpricing the chance of default across the banking sector in termsof credit default swap spreads, the iTraxx Europe SeniorFinancials, tightened by only 3.7 basis points.Tighter CDS spreads reflect reduced credit risk.
In one week in June, bank shares fell 5.5 percent and theCDS spread widened by 14 bps, indicating the credit market'smove last week was comparatively muted.
While equity market moves usually presage a matching CDSmove shortly after, when this relationship breaks down, CDS aremore than twice as likely to be correct, Parkinson said.
He said that while credit and equity markets reflected abroadly similar view of banks, the latter was over-optimistic.
"The equity market has an awful lot more froth andexuberance to unwind than credit has."
Earnings forecasts for financials have been downgraded by 6percent over the last 30 days, with shares of those yet toreport rising 3.2 percent, Thomson Reuters StarMine data shows.
Top analysts predict financials will miss consensus targetsby 0.1 percent, according to Thomson Reuters SmartEstimates, incontrast to the impressive figures managed by U.S. banks.
One factor continuing to undermine the European sector isthe weak performance of the continent's economy relative to thatof the United States.
"Banks are essentially a domestic demand proxy, and theUnited States private sector is a lot further down the recoverycurve than in Europe," Robert Quinn, chief European equitystrategist at S&P Capital IQ said.
He added that European institutions with big investment bankand trading divisions, such as Societe Generale andBarclays, could do better than retail-focused banks.
NOT ENOUGH
Even if they meet expectations, the recent rise in thesestocks means they could see only limited gains, or even fall.
While Swiss bank UBS rose after its consensusbeating results, it has since given up some of those gains.
Early reporting Nordic banks that beat forecasts, such asSweden's SHB, have seen their shares fall.
"You can see already from the Nordic results... that merelybeating earnings is not really enough. Valuations have alreadymoved to a point where they reflect forecasts," Simon Maughan,financial sector strategist at Olivetree Financial Group, said.
"There's been such a clear division between the winners inthe North and the losers in the South that everybody's verycomfortably positioned long the winners in the North, and shortthe losers in the South. So where's the next buyer for bankstocks?"
Peripheral European lenders are seen as particularlyexposed, especially if the U.S. Federal Reserve begins to slowasset purchases that have propped up markets. The stimulus hashelped the re-rating of the weakest institutions, which couldstall if investors refocus on risks in the sector.
"The political concerns are still there, the risk concernwithin the banking sector is still there, there are new stresstests... where lots of the Italian banks are going to findthemselves with serious capital shortfalls," Parkinson said.
"We don't have the growth or the earnings momentum incorporate Europe to sustain a recovery without continuedsupport."
