* 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 European bank shares driven higher by strong earnings from U.S. lenders may be set for a fall as their own results season begins, with credit markets reflecting wariness about risks glossed over by equity investors.
Forecast-beating earnings from Bank of America and Citigroup lifted shares in European banks last week.
However, the market for insurance against banks defaulting on their loans shows more caution over the European sector, which is still struggling with bad debts in the euro zone periphery and regulatory costs.
Thomson Reuters StarMine data shows the second-quarter earnings season is set to disappoint, relative to that in the United States. Early reports have not seen much of a bounce in the shares of those European banks that beat expectations.
"The credit is a lot more cautious than equity... and European financials are a major culprit from the equity standpoint: 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 from the United States, has seen buying of banks and financials more generally on the back of that, and it's ignoring the longer-standing underlying issues that are affecting Europe."
An index of European bank stocks rose 3.3 percent last week, buoyed by earnings beats by U.S. peers, but an index pricing the chance of default across the banking sector in terms of credit default swap spreads, the iTraxx Europe Senior Financials, 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 the CDS spread widened by 14 bps, indicating the credit market's move last week was comparatively muted.
While equity market moves usually presage a matching CDS move shortly after, when this relationship breaks down, CDS are more than twice as likely to be correct, Parkinson said.
He said that while credit and equity markets reflected a broadly similar view of banks, the latter was over-optimistic.
"The equity market has an awful lot more froth and exuberance to unwind than credit has."
Earnings forecasts for financials have been downgraded by 6 percent over the last 30 days, with shares of those yet to report rising 3.2 percent, Thomson Reuters StarMine data shows.
Top analysts predict financials will miss consensus targets by 0.1 percent, according to Thomson Reuters SmartEstimates, in contrast to the impressive figures managed by U.S. banks.
One factor continuing to undermine the European sector is the weak performance of the continent's economy relative to that of the United States.
"Banks are essentially a domestic demand proxy, and the United States private sector is a lot further down the recovery curve than in Europe," Robert Quinn, chief European equity strategist at S&P Capital IQ said.
He added that European institutions with big investment bank and trading divisions, such as Societe Generale and Barclays, could do better than retail-focused banks.
Even if they meet expectations, the recent rise in these stocks means they could see only limited gains, or even fall.
While Swiss bank UBS rose after its consensus beating results, it has since given up some of those gains.
Early reporting Nordic banks that beat forecasts, such as Sweden's SHB, have seen their shares fall.
"You can see already from the Nordic results... that merely beating earnings is not really enough. Valuations have already moved 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 in the North and the losers in the South that everybody's very comfortably positioned long the winners in the North, and short the losers in the South. So where's the next buyer for bank stocks?"
Peripheral European lenders are seen as particularly exposed, especially if the U.S. Federal Reserve begins to slow asset purchases that have propped up markets. The stimulus has helped the re-rating of the weakest institutions, which could stall if investors refocus on risks in the sector.
"The political concerns are still there, the risk concern within the banking sector is still there, there are new stress tests... where lots of the Italian banks are going to find themselves with serious capital shortfalls," Parkinson said.
"We don't have the growth or the earnings momentum in corporate Europe to sustain a recovery without continued support."