Morgan Stanley has upgraded the European semiconductor sector to Overweight, citing improving valuation dynamics and growing diversification inflows into European equities. The bank's strategists argue that bottom-up fundamentals are now driving top-down performance, making selective stock picking more attractive than broad market exposure.

The upgrade is anchored in semiconductor equipment names, where ASML has been a dominant driver, accounting for over half of the bank's Top Picks gains year-to-date. The bank notes that ASML represents roughly 80% of the MSCI Europe Semis index, making it a critical component for investors seeking exposure to the AI capex cycle.

Morgan Stanley sees the main risk in the AI capex cycle shifting from demand to execution and transition, positioning future bottlenecks as key winners. This dynamic favors European semicap exposure, particularly firms tied to extreme ultraviolet (EUV) lithography technology. The bank expects order intake over the next several quarters to confirm higher foundry and memory capex into 2027.