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A statue is pictured next to the logo of Germany's Deutsche Bank in Frankfurt, Germany, September 30, 2016.KAI PFAFFENBACH/Reuters

While possibly Europe's biggest "pain trade," fund managers are under pressure to buy banking stocks despite the deep problems of Deutsche Bank AG and some other lenders in the region. A 9-per-cent slump to record lows on Friday for the German lender was rapidly reversed in afternoon trade, exemplifying the difficulties investors face in staying bearish on a sector that still faces fundamental problems.

As the third quarter draws to a close, the main European banking index has rallied 19 per cent from the start of July, with a number of constituent stocks rising sharply in contrast to those of some German and Italian banks.

This presents a dilemma for fund managers who, following a long period of poor overall performance by European banking shares, had taken heavily underweight positions in the sector.

With the index still down around a quarter this year, those who shifted toward other sectors have outperformed benchmark indices against which their funds are measured.

But now they find themselves in a tough spot. If the banking sector keeps rising overall, they risk losing these gains and underperforming for the full year – unless they raise the proportion of bank shares in their portfolio at least to neutral, matching the weightings in the benchmark indices.

According to strategists at Citigroup, European banks are the worst-performing combination of business sector and geographical region among the 285 they have tracked over the past decade.

Acknowledging that buying into them now constitutes "the world's biggest contrarian trade," the analysts led by Jonathan Stubbs said in a note to clients: "History says Buy, but our key message is do not Underweight the sector."

Chasing the rally remains risky. The recent slump in shares of one of the region's largest lenders, Deutsche Bank, in the aftermath of a proposed fine by the U.S. Department of Justice has underlined the sector's longer-term problems, especially in the realms of regulation and financing.

Commerzbank AG will cut more than a fifth of its work force and suspend its dividend while uncertainty about the cleanup of bad debts at Italian banks has also compounded long-standing worries over eroding profitability and rising regulatory costs.

Swiss investment banks are also struggling with negative interest rates. Credit Suisse says clients are sitting on record amounts of cash owing to uncertainty in the global economy, leading to low levels of transactions and fee income. Chief executive Tidjane Thiam said this week that banks are generally "a bit difficult to invest in."

Nevertheless, starved of returns and loathe to move into highly valued sectors such as health care, investors have bought beaten-down shares – including in banks that suffered the biggest hits in a sell-off that followed Britain's vote to leave the European Union on June 23.

Since the lows hit on July 6, French bank Natixis, ING Groep of the Netherlands and Scandinavian lenders such Nordea and Sydbank have all risen more than 25 per cent. In Britain, shares of HSBC Holdings PLC and Barclays PLC are also up about a quarter.

The underperformers are dominated by Deutsche, the Swiss investment banks and a handful of Italian lenders – suggesting investors are discerning between the weaker and healthier banks rather than treating the sector as a single trade.

Deutsche's chief executive has told staff the bank remains robust despite the demand for up to $14-billion (U.S.) from U.S. authorities for misselling mortgage-backed securities.

Bankers and policy makers are also playing down comparisons between the problems at Germany's largest lender and the collapse of U.S. investment bank Lehman Brothers in 2008, which sent shockwaves through global markets.

Nevertheless, investors cannot ignore the risk of contagion and that Deutsche's problems could spread to other banks that deal with it, should it slide deeper into crisis.

Still, signs of a possible subtle shift in monetary policies globally away from negative interest rates, prompted by a Bank of Japan policy overhaul last week, have raised hopes of a profit recovery for the banks.

This, combined with the multiyear low valuations and fund managers' heavily underweight positions, suggests there may be room for the rally to run longer, although many remain cautious.

"I'm not saying that it is now time to buy banks, I'm asking myself the question about whether it is time to buy banks," said Guy de Blonay, a portfolio manager specializing in financials at Jupiter Asset Management.

"I think valuations may be pricing in too much bad news, because the market was pricing a negative rate getting worse and worse as we went along," he said.

Mr. Blonay's Jupiter Financial Opportunities Fund had only two banks in the top 10 holdings at the end of August, Banque Cantonale Vaudoise of Switzerland and Copenhagen-based Danske Bank.

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