• South Korean President Yoon Suk Yeol abruptly announced plans to impose an emergency period of martial law on Tuesday, although back-tracked on the shock order shortly afterward.
• The political whiplash thrust South Korea, a key U.S. ally and critical link in international supply chains, into the global spotlight and rattled financial markets.
• Trinh Nguyen, senior economist at Natixis, described Yoon's push to declare martial law as a "very, very poor decision" and one that hits South Korea at a bad time.

An extraordinary political drama in South Korea is likely to compound an already gloomy outlook for Asia's fourth-largest economy, analysts say, although some see reason to be more upbeat if a deeper crisis can be avoided.

South Korean President Yoon Suk Yeol abruptly announced plans to impose an emergency period of martial law on Tuesday evening, citing the need to protect the country from North Korea's "communist forces" and to eradicate "anti-state forces."

The shock declaration, which was widely seen as a response to domestic pressures, was reversed just hours later. Yoon's decision to back-track on the order came after nearly 200 lawmakers forced their way into the National Assembly to unanimously vote to block the move.

The political whiplash thrust South Korea, a key U.S. ally and critical link in international supply chains, into the global spotlight and rattled financial markets.

U.S.-listed Korean equities fell sharply on Yoon's initial martial law order, while South Korea's won notched a fresh two-year low against the U.S. dollar. The currency has since recovered most of its losses.

Shortly before markets opened on Wednesday, Kim Byung-hwan, vice-minister of economy and finance, said that the regulator was ready to deploy 10 trillion won ($7.06 billion) to stabilize the stock market "at any time," South Korea's Yonhap News Agency reported.

South Korea's Kospi index closed 1.44% lower on Wednesday, trimming losses of over 2% earlier in the day as opposition lawmakers launched impeachment proceedings against Yoon.

"For now we have a much calmer situation, but given how important South Korea is to the global supply chain this remains a story to keep on our radar," strategists at Deutsche Bank said in a research note published Wednesday.

What next for Korean stocks?

Jonathan Garner, chief Asia and EM equity strategist at Morgan Stanley, told CNBC's "Street Signs Asia" on Wednesday that the Wall Street bank was underweight on Korean stocks.

"Our view on the Korean market is that it is not that well positioned in a global economic slowdown and particularly as one of the most trade-exposed markets and geographies we cover, with all the tariff and non-tariff issues that are underway," Garner said.

"But also, there is a semiconductor cycle that is starting to form on the downside, and in addition the auto sector is quite impaired globally — and they are heavily represented in the Korean market," he continued.

"Our economists even before these recent events were expecting growth to slip below 2% for Korea next year, which is one of the biggest decelerations that we would see globally."

Tech giant Samsung, South Korea's biggest company, saw shares drop 1% on Wednesday, while battery-maker LG Energy Solution and automaker Hyundai Motor logged losses of 2.8% and 2.4%, respectively.

Rory Green, chief China economist and head of Asia research at TS Lombard, said in a research note published Wednesday that negative price action and volatility is likely to continue across Korean assets and interlinked markets, particularly Asian foreign exchange markets.

South Korea's won was last seen trading flat at 1,414.22 against the greenback, having depreciated to 1,444.93 on Tuesday — its weakest level since October 2022, according to LSEG data.

Trinh Nguyen, senior economist at Natixis, described Yoon's push to declare martial law as a "very, very poor decision" and one that hits South Korea at a bad time.

"Martial law hasn't been introduced since 1979 and is seen as deeply negative. So, the reversal of it is positive. However, it has introduced a lot of political uncertainty moving forward, particularly the future of President Yoon," Nguyen told CNBC's "Squawk Box Asia" on Wednesday.

"It is not a positive time for South Korea, right? The chip cycle is on a downturn as you can see that the October exports is in contraction, the [Bank of Korea] have to cut rates [and] domestic demand is rather weak," she continued.

"So, we really need a strong government to have a budget that is fiscally supportive not just for the short term, but longer term to deal with the challenges coming from not just China but also potentially tariffs," Nguyen said.

Investor sentiment could turn for the better

Not everyone was as downbeat on the market implications of South Korea's unfolding political drama.

"For a start, new reports are now suggesting that Yoon will be impeached or resign fairly quickly, which might help investors further draw a line under the affair," Thomas Mathews, head of markets for Asia Pacific at Capital Economics, said in a research note published Wednesday.

"Presidential impeachments aren't unprecedented in Korea, and the country's equities, at least, ultimately fared quite well during the most recent one in 2016/2017," he added.

While Matthews acknowledged the chaos comes at a challenging time for South Korea, the team at Capital Economics said there is some reason to be more upbeat as long as a deeper crisis can be avoided.

"Korea's large tech companies are, after all, generally well positioned to benefit from the current enthusiasm about AI and tech more broadly. So if investor sentiment on the country does, eventually, turn for the better, we think it could do so quite sharply," Matthews said.

"But there's probably more water to flow under the bridge first," he added,