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Chipper mood on European earnings warrants caution

By Atul Prakash and Vikram Subhedar

By Atul Prakash and Vikram Subhedar

LONDON (Reuters) - The mood among analysts on the outlook for European earnings is the brightest in 6 years, although a combination of higher valuations and optimistic projections leaves the bar for disappointment in the imminent results season fairly low.

Lofty expectations at the start of the calendar year are not new. In every year since 2010, forecasts have called for double-digit earnings growth in Europe only for actual annual results to significantly underwhelm.

Meanwhile, a global rally in stock markets, stoked by hopes of better economic growth, the return of inflation in Western countries and seemingly unperturbed by a swathe of political risks in Europe and the United States, has lifted valuations back to or above long-term averages.

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European shares <.STOXX> are up nearly 11 percent since their early November lows following Donald Trump's win in the U.S. presidential election with the banks, commodity-related sectors and industrials leading the charge as investors switched out of defensive, dividend-paying sectors and into stocks closely geared to the economic cycle.

Earnings are forecast to grow roughly 14 percent in Europe this year and companies are seeing more analyst upgrades than downgrades for the first time since 2010, according to Thomson Reuters data.

While fundamental factors such as improving global growth forecasts, higher commodity prices and steeper bond yield curves have underpinned improving earnings, concerns are creeping in on whether the better economic backdrop is already baked into higher stock prices.

Valuations for European shares are back to roughly 15 times forward earnings, bang in line with long-term averages.

"Investors should be cautious about these headline earnings numbers for 2017," said Alex Dryden, global market strategist at JPMorgan Asset Management.

"Analyst forecasts typically start the year at an overly optimistic level before falling sharply over the course of the year," said Dryden.

A strong run-up in share prices ahead of earnings makes it that much harder for relatively good results to spur further buying.

UBS results on Friday were a case in point. The Swiss bank reported better-than-expected results though shares fell more than 3 percent. They had risen more than 20 percent in the three months prior.

In terms of growth, European banks remain the sector seeing the strongest forecasts. Earnings for the sector are seen growing more than 20 percent over the next 12 months, followed by the technology sector at 15 percent. Insurers and utilities are seeing the softest earnings growth of just under 4 percent.

A healthy earnings season in the United States, where fourth quarter earnings are on track for their biggest increase in two years, has also bolstered the outlook for Europe Inc.

Some factors such as higher commodity prices and a steeper yield curve which have benefited U.S. firms are likely to spill over into Europe too.

Commodities and financials have a higher weighting in European indexes relative to the U.S., suggesting their impact is even more pronounced, JP Morgan Asset Management's Dryden said.

One worry among investors, however, is that much of the improvement in outlook hinges on Donald Trump's sweeping agenda of tax cuts, infrastructure spending and a healthcare revamp.

“Worldwide, a lot of Trump optimism is discounted in stocks. This makes them vulnerable to growth disappointments," said Philippe Gijsels, head of research at BNP Paribas Fortis in Brussels.

(Reporting by Vikram Subhedar; Editing by Toby Chopra)