European shares extend rally on hopes of U.S. debt deal


* FTSEurofirst 300 up 0.4 pct, Euro STOXX 50 flat

* Euro STOXX 50 touches new 2-1/2 year high

* Europe's earnings momentum improves, but still negative

* Philips, Accor, Whitbread gain after upgrades

By Alistair Smout

LONDON, Oct 11 (Reuters) - European stocks edged higher onFriday, building on a rally in the previous session, asinvestors hoped that an agreement would finally be reached inWashington on the U.S. debt ceiling.

At 1454 GMT, the FTSEurofirst 300 index of topEuropean shares was up 0.4 percent at 1,249.79 points, aftersurging 1.7 percent on Thursday.

The euro zone's blue-chip Euro STOXX 50 indexwas flat at 2,971.39 points, after hitting a new 2-1/2 yearhigh.

Stocks around the world had lost ground in the past threeweeks after an impasse in U.S. budget talks led to a partialgovernment shutdown and sparked concerns about the extension ofWashington's borrowing authority beyond an Oct. 17 deadline.

On Thursday, President Barack Obama and Republican leadersappeared ready to end the deadlock. One senior Republican saidan agreement could come on Friday.

After having dropped seven of the previous nine sessions,the FTSEurofirst has rebounded, adding 2 percent over the last 2sessions.

"Over the last few days we've seen something of a turnaroundon optimism that the debt ceiling will get raised, and at leastthere'll be a temporary measure if not a permanent measure. Theconfidence seems to be returning to the market," Manoj Ladwa,head of trading at TJM Partners, said.

The Euro STOXX 50 Volatility index, known as theVSTOXX, was down 6.4 percent, indicating a drop in investors'risk aversion. Europe's widely-used gauge of investor sentiment,which is based on put and call options on Euro STOXX 50 stocks,has fallen 21.7 percent since a peak hit on Wednesday.

"Even though investors get nervous when political tensionsrise, the backdrop for equities remains quite positive: veryaccommodative central banks, improvement on the macro front, andrelatively good corporate fundamentals," said JeanneAsseraf-Bitton, head of global cross-asset research at LyxorAsset Management, which has $98 billion under management.

"It's sort of a 'sweet spot' for stocks. Now, with theearnings season set to start, we need to see an improvement inthe earnings momentum. It has improved lately in Europe,although it remains negative for now."

Europe's earnings momentum - analyst forecast upgrades minusdowngrades as a percentage of total - has recently improved,from minus 3.2 percent in July to minus 2.1 percent currently,data from Thomson Reuters Datastream shows.

Many of the top gainers were spurred by upgrades. Philips gained 2.6 percent after being raised to "buy" from"neutral", while Costa-owner Whitbread and hoteloperator Accor rose 2.6 percent and 1.6 percentrespectively after receiving upgrades from Citi.

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