European shares drifted higher on Thursday on hopes a crucial EU crisis summit to resolve the euro zone debt crisis will result in a positive agreement, with analysts saying the market had potential to gain around 5 percent on such an outcome.
However, deteriorating macroeconomic conditions in Europe and its impact on company earnings could start to weigh on equities in the new year, unless European policymakers took urgent measures to boost confidence and brought the region's economic recovery back on track, analysts said.
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Defensive stocks were in demand, with the healthcare sector rising 1.1 percent to top the gainers list. At 1219 GMT, the FTSEurofirst 300 index of top European shares was up 0.1 percent at 989.85 points. The index hit a five-week high in the previous session on optimism ahead of the summit.
Jose Manuel Barroso, president of the European Commission appealed to EU leaders to set aside their differences and unite to rescue the euro. France and Germany planned to lobby for their plan to amend the European Union treaty to toughen budget discipline, which they want to have ready by March.
Not all euro zone countries are comfortable with all the French and German proposals, with Finland opposed to their call for majority votes on major policy decisions.
"The market is not expecting the full details until the weekend. In that case you don't want to end Friday with a lot of exposure to positions which could turn on Monday morning," Peter Dixon, global financial economist at Commerzbank, said.
"I don't think there is a huge amount of upside potential right now because the economic data, particularly from Europe, is looking grim. I think shares could gain about 5 percent on a positive outcome," he said, adding that a disappointment could result in a drop of 5 to 10 percent in the near term.
Analysts said that an agreement on a concrete plan to solve the debt crisis could improve sentiment for some time, but that was not going to reverse the likelihood that the first few months of 2012 were going to be grim from an economic perspective, which could have an impact on company earnings.
The Bank of France predicted that French growth will stall in the final quarter of the year, flagging a slowdown to zero growth after the euro zone's second-biggest economy grew 0.4 percent in the previous quarter.
With financial market doubts hanging over the euro zone's EFSF financial rescue fund, many economists say that the most effective way of getting a grip on the crisis would be for the ECB to buy euro zone government bonds more aggressively.
The ECB's policy-making governing council will announce its policy decisions at 1245 GMT, with economists widely expecting a quarter-point interest rate cut to a record low of 1.0 percent, and moves to give banks longer-term liquidity on easier collateral terms.
Strategists said the market was also pricing in the ECB starting quantitative easing.
Jeremy Batstone-Carr, strategist at Charles Stanley, said the market could fall 6 percent if the ECB did not indicate it would print money and only "vague platitudes" emerged from the summit.
"I can't see where a continuation of this rally is going to come from," he said.