If you were hunting for a group of stocks to dethrone the Magnificent Seven ("Mag Seven"), there is a good chance European banks were not at the top of your list. But looking at returns over the past 12 months and on a year-to-date basis, that is exactly what has happened.

European banks have had a stellar run, significantly outpacing the Mag Seven group of US technology leaders and the S&P 500 Index. The MSCI Europe Bank Index has returned 63.6% over the year to the end August, on track for its best calendar year since 1997. By comparison, the Mag Seven returned 9.9%.

Admittedly, this is a short period, but it is a good reminder of the benefits of a broadly diversified portfolio. Even the most maligned sectors can rebound, and they often do at times when beloved areas of the market are pulling back, helping to smooth out overall returns.

As a portfolio manager, I recognised the opportunity in 2022 when I believed interest rates in Europe would increase due to the potential for persistent inflation in the wake of the COVID-19 pandemic, the reshoring of manufacturing activity in many countries and Russia's invasion of Ukraine.

At that time, many European banks were out of favour. They traded 30% to 60% below book value — a massive discount to large US banks. Higher interest rates can be beneficial to banks because they lead to higher net interest income — a significant revenue stream for banks and a key indicator of their financial health.

The rise of European banks comes amid a broader rally for non-US stocks, helped by large-scale German stimulus, a weakened US dollar and concerns about the outsized positions held by certain US technology stocks in global market indices.

Here are five reasons why European banks are back in favour and why I believe they continue to look attractive.

1. A normal interest rate environment

Banks have endured eight years of negative interest rates from the European Central Bank (ECB). The policy changed in July 2022, and it has helped boost net interest income. Rates rose to 4% before the ECB began to loosen monetary policy this year. But I think this rate-cutting cycle is near an end. Current rates are at 2%. The yield curve is steeper (which is favourable for banks) and forward rate expectations have also stabilised. As I said, my view is that inflation will be persistent. Typically, central banks keep rates higher to blunt inflation.

2. Regulatory burdens have eased

Banks amassed significant capital reserves in the wake of the sovereign debt crisis, and regulators have lowered certain threshold requirements. One outcome has been growing dividend payouts. For example, Italian bank UniCredit increased its annual dividend to $2.40 a share in 2024, up from 12 cents in 2020. Also, Spanish bank BBVA’s current annualised dividend of $0.74 is up 24.4% from last year.

3. Loan growth is picking up

We are starting to see signs of loan growth, something virtually unheard of since the 2010 European sovereign debt crisis that triggered financial bailouts for several countries. As German stimulus is unleashed moving into 2026, I would anticipate loan growth to accelerate across Europe, particularly in Germany. I also do not anticipate loan losses will be an issue.

4. Tariff risks are low

In contrast to the automotive sector, many European banks are domestically focused, conducting their operations primarily at the country level. They are not trading physical goods from one country to another.

5. Valuations are reasonable

Despite the rally, European banks trade at reasonable valuations given what is expected to be a reacceleration of economic growth across Europe. Earnings growth estimates for 2025 and 2026 have also increased.

Valuations are also not demanding compared to their US counterparts on a price-to-book and price-to-earnings basis. For example, on 9 September, Deutsche Bank was trading at 0.9 times book value and Banco Santander at 1.2 times, versus 2.4 times for J.P. Morgan and 1.4 for Bank of America.

The importance of a globally diversified portfolio

The remarkable run of European banks is a good reminder to consider a globally diversified portfolio and maintain a long-term perspective. As the equity market continues to broaden, we may find that even the most unlikely suspects can add value.