LONDON (Reuters) - Citi analysts upgraded their recommendation on Europe's beleaguered banks to "overweight" within regional portfolios, citing signs of improvement in the credit cycle and loan growth as well as cheap relative valuations.

Citi acknowledged headwinds facing the sector such as pressure on profits from ultra-low interest rates, regulatory costs and potential dilution, but added it saw negative risks as being more on selective, individual banks rather than being system-wide.

European banks are trading at their cheapest relative to U.S. peers, Citi said, with stocks priced for disappointments rather than reducing risks.

The volatile trading in the shares of European banks, the biggest regional laggards in terms of year-to-date performance, has put portfolio managers in a tough spot.

"European banks have been the lightning rod for all post-GFC (global financial crisis) macro risk," said Citi analysts in a note to clients, referring to the post-Lehman bankruptcy period in financial markets that has been punctuated by a slew of risk-off events in Europe from a sovereign debt crisis to more recently the potential fallout of the UK leaving the European Union.

In their analysis across 285 global sector and regional combinations, European banks are among the worst performing over the past decade, Citi said, adding that buying them would be the world's biggest contrarian trade.

The STOXX Europe 600 banking index <.SX7P> was up 0.8 percent on Thursday, but remains down by around 20 percent since the start of 2016.

(Reporting by Vikram Subhedar; Editing by Sudip Kar-Gupta)