Morgan Stanley has upgraded its rating on South Korean equities to "Overweight," citing that the severe deleveraging process is nearing its conclusion. The KOSPI's valuation has fallen to historically extreme lows, presenting a more attractive entry point for investors.

According to the firm's latest Asian emerging market equity strategy report, Morgan Stanley has set a KOSPI target of 9,000 points, implying approximately 36% upside from current levels. The report notes that the KOSPI's 12-month forward price-to-earnings (P/E) ratio has dropped to 5.7 times, below its previous historical low. This valuation already reflects the market's pessimistic outlook on the sustainability of memory-driven earnings in 2026.

Morgan Stanley believes the 39% KOSPI correction was primarily technical in nature, rather than a deterioration of fundamentals. With approximately 75% of hedge fund deleveraging completed, the asset under management (AUM) of leveraged ETFs linked to Samsung Electronics and SK Hynix has shrunk by about 70% from its peak. The market's positioning structure has improved significantly. The report identifies three major semiconductor catalysts as the core drivers for the next phase of the South Korean market's rally.

Deleveraging Nearing Completion, Cleaner Positioning

Morgan Stanley's Prime Brokerage data shows that Asian hedge funds' deleveraging process is about 75% complete. Global hedge funds' gross exposure to South Korea has fallen from a peak of 3.8% to 2.7%, a 28% decline, while net exposure has dropped from 8.8% to 5.6%, a 36% reduction.

Meanwhile, the AUM of leveraged ETFs linked to Samsung Electronics and SK Hynix has plummeted from a June peak of approximately $400 billion to around $118 billion, a decline of about 70%. The short gamma on these leveraged ETFs has also fallen from an extreme level of $867 million at the end of June to $288 million, a 67% drop.

Morgan Stanley's South Korea Capitulation Index has fallen to -2.53, its lowest level since 2008, excluding the European debt crisis and COVID-19 pandemic periods, when it reached -3.1. The report notes that historically, the KOSPI tends to rebound 10% to 30% within 30 trading days after its realized volatility hits a peak.

On the retail investor side, margin debt has fallen 14% from its late June peak, representing a reversion of about 30% toward the post-2020 average, though absolute levels remain elevated. The report suggests that renewed foreign inflows will be the primary driver of further gains, but market volatility is expected to remain high in the near term.

Valuations Below Historical Lows, Earnings Growth Expectations Remain Strong

The KOSPI's current 12-month forward P/E ratio of 5.7 times is at the 2nd percentile of its 10-year history, having fallen below its previous historical low. Excluding Samsung Electronics and SK Hynix, the KOSPI's forward P/E is 10.8 times, down about 27% from its recent peak of 14.8 times.

From an earnings growth perspective, the consensus expects MSCI Korea's earnings per share (EPS) to grow by 312% in 2026. More notably, consensus forecasts a compound annual growth rate (CAGR) of approximately 20% for EPS from 2027 to 2028, which is higher than comparable forecasts for the United States and India.

Morgan Stanley believes that, at current valuation levels, the market has already priced in a significant downturn in memory earnings. Even if memory earnings consolidate over the next two years, Korean equities are still expected to deliver excess returns relative to the broader emerging market.

Three Chip Catalysts: Capital Management, HBM4 Pricing, and iPhone Cycle

Morgan Stanley's Asia tech team lead, Shawn Kim, highlighted three near-term catalysts for Korean chip stocks in the report.

First, capital expenditure. The capital management moves of Samsung Electronics and SK Hynix are seen as the most important near-term catalyst. The market awaits specific announcements from both companies regarding "value-up" programs and capital returns. The timing is unclear, but the expectation itself is a potential catalyst.

Second, HBM4 pricing. Samsung Electronics recently indicated that HBM4 will account for about 60% of its total HBM sales by the end of next year. If HBM4 pricing reaches the market's expected level of over $3 per gigabit, it would be a positive catalyst for overall DRAM pricing in 2026-2027.

Third, the iPhone 18 launch cycle. Mobile devices still account for 30% to 40% of global DRAM demand and 25% to 30% of NAND demand. Feedback from Korean Apple supply chain members (such as LG Innotek) suggests that Apple is optimistic about the iPhone 18 cycle, forecasting shipment growth of 5% to 10% year-over-year. The iPhone 18 is set to launch in September, with initial models featuring the Pro series (including Pro, Pro Max, and a foldable device). Strong sales would positively impact Samsung Electronics and SK Hynix.