LONDON (Reuters) - Strong demand for premium foods and clothing helped British grocer J Sainsbury (>> J Sainsbury plc) to beat Christmas sales forecasts, though it continued to lose market share to discounters and warned of another tough year for mainstream supermarkets.

The company, which trails troubled market leader Tesco (>> Tesco PLC) and Wal-Mart Stores' (>> Wal-Mart Stores, Inc.) Asda by annual sales, said on Wednesday it expected falling grocery prices and intensifying competition to offset the benefits of an improving economy.

While shoppers' disposable incomes have been increasing, helped by lower fuel prices, there has not been a corresponding pick up in food sales, Chief Executive Mike Coupe said.

"It’s undoubtedly the case that customers have a little bit more money in their back pocket. They are choosing currently to spend that on other items," he told reporters.

Britain's main supermarket groups have been hit hard by the rise of discounters such as Aldi and Lidl, and are also struggling to adapt to changing shopping patterns as customers buy more online and locally rather than at out-of-town stores.

Sainsbury's said sales excluding fuel at stores open more than a year fell 1.7 percent in the 14 weeks to Jan. 3, its fiscal third quarter.

That was better than a second-quarter drop of 2.8 percent and analysts' forecasts for a decline of 2.5-4.4 percent, helped by demand for its premium "Taste the Difference" food range, as well as a 10 percent rise in clothing sales and a 16 percent increase in sales at convenience stores.

But analysts said Sainsbury's remained vulnerable to a fight back from Tesco, whose new chief executive is expected to unveil price cuts on Thursday, and noted it was still losing share to discounters and upmarket chain Waitrose.

Lidl said this week sales rose more than 20 percent year-on-year over Christmas, while Waitrose posted a 2.8 percent increase in same-store sales.

"The group does not seem to be in control of its own destiny to our minds. In particular, we harbour concerns that Sainsbury's is under-performing the sector when the market leader Tesco is also behind the curve," said Shore Capital analyst Clive Black.

Shares in the 145-year-old Sainsbury's, down 36 percent during the last year, were 1.2 percent lower at 231.72 pence by 1155 GMT, reversing early gains.

"Sainsbury's numbers were better than expected but I am not a buyer of the stock for now, as top line guidance remains unchanged," said Securequity sales trader Jawaid Afsar.

Sainsbury's forecast same-store sales would fall about 2 percent in its fourth quarter.

PRICE WAR

Until early last year Sainsbury's had been outperforming its main rivals, reporting nine unbroken years of sales growth with a strategy focussed on own-brand products, the quality, provenance and ethical credentials of its food, and on expanding its fast-growing convenience and online businesses.

Compared with Tesco, it also excelled operationally, with clean and uncluttered stores, as well as good product availability and customer service.

But it has now posted four straight quarters of falling sales amid an escalating price war.

Asda said on Tuesday it was investing 300 million pounds in the first quarter of 2015 to cut prices on 2,500 lines, while No.4 player Morrisons (>> WM Morrison Supermarkets PLC) is also lowering prices.

Sainsbury's said in November it would cut costs, dividends and new store openings to fund an extra 150 million pound investment in lower prices.

This week, it cut prices on more than 700 products, including meat, fish and poultry.

"Whatever happens we will invest in price, we will remain matching our competitors toe to toe," said Coupe.

(Additional reporting by Neil Maidment and Sudip Kar-Gupta; Editing by David Clarke and Mark Potter)

By James Davey and Kate Holton