UPDATE 2-Cathay Pacific narrows losses on higher air fares, flags better H2

* Posts loss of HK$263 million for H1 2018; costs rise

* Shares drop as much as 3.3 percent to lowest since December

* Forecasts stronger second-half performance (Recasts, adds analyst comment)

SHANGHAI/SINGAPORE Aug 8 (Reuters) - Cathay Pacific Airways Ltd on Wednesday posted a narrower half-year loss on a strong rise in airfares and cargo rates and flagged expectations for a better second half, although its failure to curb costs fuelled market concerns.

Shares of the Hong Kong airline fell 3.3 percent to their lowest since December after results showed expenses offset a better-than-expected rise in yields and higher revenue, casting a shadow on Cathay's three-year transformation programme.

The airline is halfway through its turnaround schedule that has been designed to cut costs and increase revenue, after back-to-back years of losses, to allow it to better compete against rivals from the Middle East, mainland China and budget airlines.

Cathay has reduced jobs, invested in product improvements such as better business class meals and new Airbus SE A350 jets and is adding more economy seats to older Boeing Co 777s in a bid to boost business.

In a sign the measures have started paying off, Cathay's revenue grew 15.7 percent to HK$53.1 billion ($6.76 billion) in the first half, while regional rival Singapore Airlines Ltd saw a 0.5 percent drop over April to June.

However, expenses took the shine off topline gains.

Cathay, for example, added 3.2 percent capacity over the six months to June, but in-flight service and passenger expenses rose by 8.8 percent, outpacing a 7.6 percent rise in yields or passenger fares. Fuel costs and airport charges also rose.

It makes sense for Cathay to continue to invest in its product to stay ahead of the competition because 40 percent of its revenue is from premium traffic, but there are risks, said Corrine Png, CEO of transport research firm Crucial Perspective.

"This strategy works well in a bull market but in the event of a major economic slowdown, it would be challenging for Cathay to lift its yields further," she said.

SEES STRONGER H2, AS USUAL

Cathay Chairman John Slosar said while a stronger U.S. dollar and economic uncertainty arising from mounting global trade tensions remain challenges, the airline expects a better second-half performance, as is usual.

The company expects "passenger yields to continue to improve and the cargo business to remain strong", Slosar said in a statement on Wednesday.

Cathay is expected to swing to a HK$1.2 billion profit for 2018, according to the average of 17 analysts polled by Thomson Reuters I/B/E/S, as out-of-the-money fuel hedges roll off.

For the first half, Cathay reported a HK$263 million loss and declared an interim dividend of HK$0.10, after not paying one last year. In 2017, it posted its worst January-June loss in at least 20 years of HK$2.05 billion.

Cathay's core airline business, excluding earnings from "associates" like its 18 percent stake in Air China Ltd and a cargo joint venture, posted a loss of HK$904 million in the first half.

Lower results at Air China Cargo, driven by a weaker yuan, led to a HK$73 million decline in its share of profits from subsidiaries and associates.

The weaker yuan could also dampen Cathay's share of earnings from Air China, which are reported on the basis of a three month delay, in the second half, Png said.

Cathay shares were down about 2 percent at HK$11.8 by 0725 GMT, in a wider market that was mostly steady. ($1 = 7.8497 Hong Kong dollars) (Reporting by Brenda Goh in Shanghai and Jamie Freed in Singapore; Editing by Himani Sarkar)