May 25 (Reuters) - Europe's STOXX 600 closed at its highest level in over two months, recovering all its losses since the start of the Middle East conflict, lifted by growing expectations for a U.S.-Iran peace deal and enthusiasm for AI companies.
The pan-European STOXX 600 (.STOXX), closed 1% higher at 631.63 points, less than 1% away from its February record high.
Banks (.SX7E), led the charge with a 2% jump, while airlines also advanced as Brent crude oil slid 5% to around $98 a barrel. Lufthansa (LHAG.DE), and Air France KLM (AIRF.PA), were up 3.4% and 6.2%, respectively.
Most STOXX 600 sectors were higher, while energy (.SXEP), and telecommunications (.SXKP), lost about 0.1% each.
Investors drew comfort from U.S. President Donald Trump's comment on Saturday that a framework to reopen the Strait of Hormuz had been "largely negotiated", while Iranian officials were in talks with Qatar's prime minister on a potential deal.
"There's surely room for more of a rally if the good news is confirmed. But there are a few things that might hold it back," analysts at Capital Economics said in a note.
Citing factors that they anticipate would cap a rally, the analysts said: "Energy prices won't immediately return to normal. Rate cuts are probably off the table this year in most major economies."
They added that because investor risk appetite has been resilient despite the conflict, the potential for a significant increase in the event of a peace deal is limited.
Investors will look to inflation data from major euro zone economies this week for signs of the Iran war's impact. Markets expect two European Central Bank interest rate increases of 25 basis points each by year-end, according to LSEG data.
STOXX 600 PLAYS CATCH UP
The STOXX 600 has lagged its Asian and U.S. peers, which have already rallied to record highs, given its smaller exposure to major AI-linked stocks and concerns about energy-induced inflation.
Still, the European tech sector (.SX8P), has rallied the most among STOXX 600 peers this quarter and is up over 25%.
Chip-making giant ASML (ASML.AS), added 1.5% on Monday, while AI equipment maker Schneider Electric (SCHN.PA), rose 3.1%.
Among others, Delivery Hero <DHER.DE> jumped close to 12% to an 18-month high after a report said Uber <UBER.N> was weighing a raised takeover bid for the German food-delivery group.
Delivery Hero rejected Uber's previous offer valuing it at over 11.5 billion euros ($13.4 billion).
Meanwhile, tensions escalated in Ukraine as Russia pounded Kyiv and surrounding areas. Defence stocks (.SXPARO), gained 2%.
Trading volumes were light, as the U.S. and UK markets were closed for public holidays.
Reporting by Johann M Cherian and Purvi Agarwal in Bengaluru; Editing by Sherry Jacob-Phillips, Mark Potter and Cynthia Osterman
