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After two years of a pandemic-fueled surge in demand, the semiconductor industry is experiencing some critical changes. Demand is deteriorating, supply chains are easing, and the industry has found itself in the geopolitical spotlight, taking center stage in the ongoing tensions between the US and China. In this piece, we outline the state of the semiconductor industry and highlight a few major regulatory updates from 2022 with implications for the year ahead.
The acute supply shortages that the semiconductor industry faced during the pandemic have now largely eased, although there are still pockets of tightness in certain product areas. More worrisome are the rising levels of excess inventories throughout the supply chain in markets where end demand has weakened considerably, with the most pronounced deterioration in PCs and smartphones.
This doesn’t bode well for the semiconductor industry. In fact, at the time of writing, semiconductor stocks are down about 40% year to date,1 and it’s possible that they have further to fall.
What we’ve observed in the semiconductor sector over the past few years has been anomalous. The pandemic-induced, two-year demand surge laid bare more than a decade of underinvestment in semiconductor manufacturing capacity.
It took the industry nearly a decade to digest the excess capacity that had been put in place during the tech bubble in the early 2000s, which was followed by a period of industry consolidation that resulted in a steep decline in aggregate capital intensity. Accordingly, the industry was not well-prepared to respond to the unexpected pandemic-related spike in demand.
Now, demand trends across key end markets are deteriorating, but the industry is still planning to expand capacity regardless of current underlying demand conditions for two reasons:
Semiconductor manufacturing has become a critical geopolitical issue. Nearly 70% of semiconductors are manufactured in Taiwan and China, which many view as a significant supply-chain vulnerability and risk to national security. The sector is increasingly seen as strategically important in the context of a power conflict between the US and China, and, accordingly, has been at the center of recent legislation, including:
1. The CHIPS Act of 2022, which authorizes US$52 billion in federal funding for domestic semiconductor production, as well as research and development
The US has committed to investments intended to help facilitate the reshoring of chip production, as have the EU and Japan. In response, it’s likely that China will champion domestic alternatives to US semiconductor-equipment suppliers. Current domestic suppliers are very small and far behind on the technology. We believe that they’re at least five — and more likely 10 — years behind their global competitors.
In our view, globalization has peaked, and the semiconductor manufacturing landscape will look quite different in the coming years.
2. Export restrictions on US companies that produce semiconductors in China
In October, the Biden administration implemented new restrictions on US companies that produce semiconductors in China. These will have varying impacts on specific companies, but the overall takeaway is that the US government now reserves the right to review any semiconductor-related technology sold to China.
While these restrictions have been put in place primarily to stop the shipment and manufacture of chips that could be used in military applications, in effect, they bring China’s stated ambition of becoming a leading-edge semiconductor manufacturing powerhouse to a grinding halt.
It’s worth noting that while semiconductor regulations address the hardware side of the strategic sectors in this power conflict, there could be future restrictions applied to software, biotech, quantum computing, and AI, which could further strain the already tense relationship between the US and China.
What does this mean? The last few years have not represented a “typical” semiconductor cycle and there’s no roadmap for what the trajectory of the recovery might look like from here. Unusual supply and demand dynamics are not the only challenge the industry faces.
We believe that it’s becoming increasingly important to be selective and deliberate within this space. We hold a more favorable view of companies that have the ability to control their own destiny, including those that maintain and expand domestic production capabilities. At the same time, we have become more cautious on companies with major parts of their supply chains located in China.
Despite our near-term caution, semiconductors remain essential building blocks of everything from smartphones to cars, and the secular tailwinds that underpin our longer-term optimism remain unchanged. During periods of uncertainty, we believe active managers and sector specialists may be well-placed to identify tomorrow’s winners and losers.
1As measured by the PHLX Semiconductor Sector, a Philadelphia Stock Exchange capitalization-weighted index composed of the 30 largest US companies primarily involved in the design, distribution, manufacture, and sale of semiconductors. As of 31 October 2022.
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