UPDATE 1-European shares extend rally on hopes of U.S. debt deal

Fri Oct 11, 2013 12:40pm EDT

* FTSEurofirst 300 up 0.5 pct, Euro STOXX 50 up 0.2 percent

* Euro STOXX 50 closes at 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 on Friday, building on a rally in the previous session, as investors hoped an agreement would finally be reached in Washington on the U.S. debt ceiling which would avoid a chaotic default.

At the close, the FTSEurofirst 300 index of top European shares was up 0.5 percent at 1,250.85 points, after surging 1.7 percent on Thursday.

The euro zone's blue-chip Euro STOXX 50 index was 0.2 percent higher at 2,974.28 points - new 2-1/2 year closing high.

Stocks around the world had lost ground in the past three weeks after an impasse in U.S. budget talks led to a partial government shutdown and sparked concerns about the extension of Washington's borrowing authority beyond an Oct. 17 deadline.

On Thursday, President Barack Obama and Republican leaders appeared ready to end the deadlock. One senior Republican said an agreement could come on Friday.

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

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

The Euro STOXX 50 Volatility index, known as the VSTOXX, was down 8 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 tensions rise, the backdrop for equities remains quite positive: very accommodative central banks, improvement on the macro front, and relatively good corporate fundamentals," said Jeanne Asseraf-Bitton, head of global cross-asset research at Lyxor Asset Management, which has $98 billion under management.

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

Europe's earnings momentum - analyst forecast upgrades minus downgrades 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 3.1 percent after being raised to "buy" from "neutral", while Costa-owner Whitbread and hotel operator Accor rose 3.1 percent and 1.9 percent respectively after receiving upgrades from Citi.