* FTSEurofirst 300 down 0.1 pct
* DAX lags after surprise loss at Deutsche
* Deutsche heads for biggest one-day drop in 10 months
By Toni Vorobyova
LONDON, Jan 20 (Reuters) - European equities edged lower on Monday, retreating from 5-1/2 year highs as financial shares were hit by a surprise loss from Deutsche Bank, the first of the region's lenders to report fourth quarter earnings.
Deutsche - which had not been due to release results until Jan. 29 - fell 4.0 percent after unveiling a fourth quarter loss of 1.15 billion euros ($1.56 billion) due to heavy litigation and restructuring costs, as well as weakness in fixed income trading.
Debt sales and trading revenues fell 31 percent, year-on-year, raising concerns about performance at other banks with a large fixed income business. Underscoring the problems in that area, a source told Reuters that Swiss bank UBS will begin outsourcing its fixed income trading platform to two technology groups in an attempt to save costs.
The STOXX Europe 600 Banking Index dropped 0.8 percent , making it by far the worst performing sector.
The impact, however, was felt more broadly, with Deutsche's loss following on from a profit warning from oil major Shell last week and fuelling concerns that the earnings season will not deliver the strong results needed to justify high equity valuations and to enable further market gains.
"The market is trading on valuations which are getting closer to levels where any sort of earnings disappointment is going to be increasingly problematic," said Ian Richards, strategist at Exane BNP Paribas.
Such concerns prompted the bank to downgrade the banking sector to neutral from overweight at the turn of the year.
"The rationale was essentially valuation which ... was suggesting that share prices are increasingly contingent on earnings revisions going in the right direction. So from a risk/return perspective, I am not convinced the case for the banks is as strong as perhaps it has been," Richards said.
European equities are trading at around 13.6 times their expected 12 month earnings - around their most expensive in nine years, according to Thomson Reuters Datastream.
The pan-European FTSEurofirst 300 index was down 0.1 percent at 1,344.60 points by 1047 GMT, holding below last week's 5-1/2 year peak of 1,346.23 points.
The DAX lagged other regional bourses, down 0.2 percent as Deutsche's drop took 17 points off the German index.
On average, European companies could miss fourth quarter earnings consensus by 1.5 percent, according to StarMine SmartEstimates, which focus on the up-to-date predictions form historically most accurate analysts.
However, with SmartEstimates predicting a 3.9 percent year-on-year drop in fourth quarter earnings, the bar has been set relatively low for any possible upside surprises.
"On balance, we think this season will be an improvement in terms of earnings surprises compared to the third quarter season. Most of this expected improvement is because consensus revised down earnings estimates very substantially while the economic backdrop remained broadly unchanged," analysts at Goldman Sachs said in a note.