UPDATE 3-Lagarde ECB pick triggers euro-zone share rally as investors chase yield

* Euro zone blue chips hit mid-June 2018 highs

* Pan-European STOXX 600 highest since July 31

* EU leaders choose France's Lagarde as next ECB chief

* Euro zone bond yields touch record lows

* Defensive sectors outperform European markets

* Italian shares jump 2.4% on avoiding EU sanction threat (Updates to close)

By Susan Mathew and Thyagaraju Adinarayan

July 3 (Reuters) - Euro zone stocks surged on Wednesday as investors piled into firms with big dividends on hopes European Central Bank chief nominee Christine Lagarde will maintain the ECB's dovish stance, while Italian shares jumped over 2% on avoiding a EU sanction threat.

The blue-chip euro zone STOXX index closed up 0.9% having touched its highest level since mid-June last year, while the pan European STOXX 600 was also up 0.9% after hitting its highest since end-July last year.

The benchmark STOXX 600 index has risen 20% from a low hit in December last year.

Defensive sectors powered the rally as investors searched for yield amid expectations that interest rates will remain ultra low for longer with Lagarde at the ECB helm, replacing Mario Draghi.

Healthcare shot to multi-year highs and food & beverage reached all-time highs; real estate, which benefits from low rates, rose more than 1.3%

If she is confirmed in the post, investors hope Lagarde will continue the ECB's recent accommodative policy which, echoed by the U.S. Federal Reserve, helped European markets recover in June from a sharp fall the month before.

"The main concern for markets had been an interruption of the return to accommodative policy Draghi has outlined for September, but a continuation and even expansion of easing is possible when Lagarde assumes control in October," said David Zahn, head of European fixed income at Franklin Templeton.

"The appointment has reconfirmed the idea that the ECB will support the market over the short-to-mid-term at least."

Euro zone government bond yields fell to fresh record lows. Bank stocks, which tend to suffer in a low interest rate environment, rose 1.4%, underperforming the broader index.

Some investors cautioned that Lagarde's appointment did not change their view that the region would continue to struggle with weak growth, continued tension between Rome and Brussels over budget deficits and worries about Brexit.

"While the IMF chief is considered a qualified candidate, that won't necessarily make Europe a more attractive place to invest over a tactical horizon," said Mark Haefele, chief investment officer at UBS Global Wealth Management.

ITALY ESCAPES PUNISHMENT

Italy's MIB touched a two-month peak, with its bank index surging 5%, after the European Commission dropped its threat of disciplinary action against the country as Rome took action to bring its growing debt into line with the bloc's fiscal rules.

Putting a damper on some chip stocks was news that the U.S. Commerce Department's enforcement staff were told this week that China's Huawei should still be treated as blacklisted, a stark difference from U.S. President Donald Trump's statement over the weekend vowing to ease a ban on sales to the firm.

European chipmakers STMicroelectronics and Infineon fell 0.6% and 0.9% on the news, while Siltronic was hurt further by a Deutsche Bank target price cut.

German lighting group Osram shot up 11.5% to the top of the STOXX 600 after sources said its supervisory board is convening an extraordinary meeting on Thursday to discuss a takeover offer from private equity firms Bain and Carlyle. (Reporting by Amy Caren Daniel and Susan Mathew in Bengaluru and Thyagaraju Adinarayan in London; Editing by Arun Koyyur and Saumyadeb Chakrabarty)