European banks have had a bumper start to the year, outperforming almost all other sectors as investors reward a recent period of improved profitability — but analysts warn returns may not have as far to run in the second half. The Stoxx 600 Banks index has risen more than 28% in the first six months of this year, the strongest performance for the period since 1997, according to FactSet data. Gains have seen several banks hit decade-highs in recent weeks , including Deutsche Bank and the U.K.’s Barclays , after those lenders weathered recent market volatility to deliver strong investment banking returns . In southern Europe, lenders have been riding the high of increased M & A dealmaking, with recovering volumes and a “stabilizing” market in Spain, where the country’s largest bank Intesa Sanpaolo flagged a ” substantial increase ” in such transactions during the second half of last year. Governing the recent landscape have also been cost-cutting and restructuring pushes, with HSBC , Santander , UBS , Societe Generale and Deutsche Bank executing revamps, along with a new focus on structured financial products and trading. European banks have meanwhile significantly boosted their profits over the last three years as central banks dragged interest rates out of a decade of ultra-low territory, a shift that appears to have been belatedly priced in this year — even with rates now falling . “One might argue that investors still didn’t fully believe there had been structural change in profitability at European banks, and were concerned about lower rates causing a decline as sharply as it rose,” Johann Scholtz, senior equity analyst at Morningstar, told CNBC. “But the guidance that we saw, especially after full-year and first quarter results, pointed to margin expansion at the thin end but also the impact of lower interest rates not filtering in in a full way into profitability,” he said. The move out of negative rates in the euro area in 2022 had a greater impact on bank margins than the subsequent moves higher and lower within positive territory, Scholtz continued, with the latter still leaving lenders with room to maneuver via lengthening the duration of their balance sheets and hedging exposures. Many are also now benefiting from action taking during the ultra-low rate period, such as branch closures and increases in their capital under regulatory pressure, he added. M & A boom Among the strongest performers have been France’s Societe Generale and Germany’s Commerzbank , which have both seen their shares rocket roughly 80% in the year-to-date. As well as delivering sharply higher annual profit last year , Commerzbank has been buoyed by takeover interest from Italy’s UniCredit . The sharp increase in its value since then led UniCredit CEO Andrea Orcel to tell CNBC last month that he now sees Commerzbank as too expensive to justify an acquisition, calling any bid “far away.” CBK-FF 1Y line Commerzbank share price. Wider merger courtships still abound as cash-flush European banks hunt to achieve the scale of their U.S. peers, driving up the shares of many in the process. Santander this week unexpectedly announced it will acquire British high street lender TSB from Sabadell , while several other bids still hang in the balance. Sabadell itself is trying to shake off the advances of Spanish rival BBVA , and may have received some relief from Madrid’s pronouncement that such a merger may only proceed if the two banks do not integrate operations for at least three years. BBVA-ES 1Y line BBVA share price. As well as increasing its Commerzbank stake to a significant 28% , UniCredit has launched an offer for Italian lender Banco BPM , though faces pushback from both the Berlin and Rome administrations. Also in Italy, Monte dei Paschi (MPS) is pursuing a reluctant Mediobanca , with MPS CEO Luigi Lovaglio on Friday saying that securing even just 35% of its takeover target would be enough to control it, according to Reuters. Defense has been one sector to outpace banking gains this year, with the Stoxx Aerospace and Defense total market index soaring nearly 50% this year, against 38% for Stoxx Banks (a wider gauge than the Stoxx 600 banking index). But banks, particularly German lenders, are also benefiting from a defense boom, with the sector set to offer a long-term stream of opportunities. That’s amid Europe’s 800-billion-euro ($942.6 billion) ReArm drive and the Berlin administration’s pivot to relax its fiscal rules, both unveiled in spring. In addition, NATO last week announced intentions to raise individual allies’ financial commitments to 5% of their individual gross domestic products by 2035. Second-half concerns Morningstar’s Scholtz said that following the strength of first-half gains, he was “starting to view the sector as relatively fully valued.” Market sentiment could remain positive, but Scholtz said he struggled to see a catalyst that would significantly boost banking profitability going forward, likely leaving the best-case outcome as stability — and with risks coming from a fall in banks’ loan loss provisions or an increase in defaults.