Deglobalization, Geopolitics Fragment Semiconductors

Over the past five years, there has been a consequential shift from the pro-free trade neo-liberal model that prevailed during the post-Cold War era until 2017 toward a new era of market fragmentation and deglobalization.  In this transition, countries are increasingly viewing key economic sectors in national security terms and looking to onshore or near-shore production.

This policy change is no more evident in some areas of the economy than in semiconductors.  On October 11, the U.S. government announced the following semiconductor-related changes:

• New export licensing requirements for U.S.-made high performance artificial intelligence (AI) chips towards China
• Foreign-made chips related to AI that use American tools or software will also require a licence to be exported to China
• Export restrictions on machinery used to make chips towards China

These stipulations came two months after the enactment of the CHIPS and Science Act of 2022, which provides $39 billion in manufacturing incentives to build chips in the United States, $13 billion for research and development, as well as additional funds for enhanced security and updating legacy systems.  It is a significant move in the direction of industrial policy with little precedent in recent U.S. history and it could have a substantial impact on returns to investors in U.S. semiconductor stocks.  Moreover, it also reflects escalating geopolitical tensions between the world’s two largest economies that show little signs of near-term resolution.

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Semiconductor shares fell sharply worldwide on the news of the export restrictions and they have generally underperformed broader technology indexes such as the S&P Technology Select Index thus far in 2022. On the face of it, these two industries look closely correlated. Over long periods of time, the Philadelphia Semiconductor Index (SOX) and the S&P Technology Select Index achieve broadly similar returns (Figure 1).  Moreover, on a day-to-day basis they tend to display high correlation that has ranged from +0.78 to +0.91 on a one-year rolling basis over the past two decades (Figure 2).  

Figure 1: Overall SOX and the S&P Tech Select Sector Index appear to move in tandem

Figure 2: SOX vs. S&P Tech Select Sector Index 1Y rolling correlation ranged from +0.78 to +0.91

That said, the high correlation and general pattern of price movements belie significant differences in returns between semiconductor stocks and the broader technology sector indexes, which are dominated by cell phone manufacturers, online retailers, software firms, internet search engines, and social media companies.  For this latter set of firms, access to the latest semiconductor chips is indispensable to their businesses, but the investment returns that those firms generate can be quite different from the semiconductor sector itself.  This much is apparent when one compares the total return of SOX to the total return of the S&P Technology Select Sector Index (Figure 3).   

Figure 3: Semiconductors underperformed from 2002-12 & outperformed from 2013-21.

From 2002 to 2012, SOX generally underperformed the broader S&P Technology Select Sector Index, declining by around 50% in relative terms.  During this period, an investment in the S&P Technology Select Sector Index returned +43.6% while SOX fell by -18.5%.  Part of the reason was that semiconductor stocks might have been overvalued during the late 1990s tech boom. They also struggled to regain their footing in the decade of the business-investment-led “tech wreck” recession of 2001, which led to relatively slow growth in semiconductor demand, while the broader technology sector forged ahead with innovative products, including the rise of the first social media giants and the vast expansion of search engines and online retailing. 

During the next decade or so, this pattern of returns reversed.  While the S&P Technology Select Sector Index returned a spectacular 648%, SOX did even better, returning 1,109% to investors between the end of 2012 and the end of 2021.  A booming tech sector created enormous demand for chips. 

This year, however, has been challenging, especially for semiconductors.  While the broader technology sector lost 32.5% in value through October 12 in 2022, the semiconductor industry has lost 43% of its market capitalization.  Semiconductor shares have also been hit by sharply rising levels of inventories. 

Part of the reason may be the greater market fragmentation in the semiconductor arena.  The broader technology industry was already globally fragmented.  For example, large U.S. social media sites are already blocked in many nations, including China.  Likewise, prominent U.S. and Chinese online retailers operate in different markets and rarely compete directly.  The same can be said of search engines, which can also be cut off at national borders.  Even large U.S. cell phone manufacturers have lost most of their Chinese market share while Chinese manufacturers have lost most of their foothold in the West.

From 2012 to 2021, semiconductor manufacturers were largely immune from this sort of market fragmentation.  Now market fragmentation has come for them as well –and at a time when inventories of chips are already high.  While semiconductor stocks are broadly correlated with the overall tech sector, there can be sharp differences in returns from time to time and recent geopolitical factors may be a major driver of divergent investment returns going forward.