The Xchange Blog

Semiconductor Stocks: Collateral Damage

Trade War

Due to their considerable exposure to the Chinese market and a heavily intertwined supply chain in Asia, semiconductor stocks have seen collateral damage as the US-China trade spat has escalated. With more precise targeting technology, recent military engagements have seen unintended consequences decrease compared to what was seen even a few decades ago, but military action cannot avoid these unfortunate events and nor can a dispute played out in economic terms. To make matters worse, semiconductors are effectively everywhere today from computers to smartphones to televisions. Semis are one of the most cyclical industries as the replacement cycle for new chips is high thanks to the need for continuous reinvestment and technology innovation. Of course, like any industry, demand can also simply dry up should the buyers of semiconductors start spending less as they see less demand for end products like phones.

Semis Caught in the Crossfire

The semiconductor industry sits literally and figuratively between the U.S. and China as a considerable portion of high technology goods are made in China. As the conflict has escalated, so has damage across the industry. In particular, restrictions on selling to Huawei and overall slowing demand in China has been a drag on 2019 sales and 2020 guidance.  The monthly performance of semiconductors relative to the broader market since the unofficial start of the trade war in early 2018 has reflected this dynamic in real time. The worst relative performance (-10%) occurred in May when the trade war focused firmly on a new group of goods of which semiconductors play an integral role in producing; cellphone and laptops.

August’s better than expected performance in semi stocks during a broad-based selloff was a reflection of the Trump administration’s announcement that they would delay the 10% tariffs on those goods until December 15, so that the holiday season would not be as impacted. However, tariffs on $125 billion of Chinese imports, including smart watches and flat-screen televisions, did go into effect on September 1.

SEMICONDUCTOR PERFORMANCE HAS BEEN IMPACTED BY THE TRADE DISPUTE

Source: Bloomberg Finance, L.P., as of August 31, 2019. Semiconductors represented by the PHLX Semiconductor Sector Index and the market represented by the S&P 500 Index. One cannot invest directly in an index.

Absent the trade war and related economic slowdown, robust earnings growth for semiconductors would normally make them market darlings in a slow growth world. Even with trade headlines dragging on sentiment, semis have outperformed the S&P by 17% through September 6, 2019, but with considerably greater volatility. This has driven relative valuations to be back on their high end over the last five years. However, using price-to-earnings implies semiconductors are inexpensively valued, but we prefer to use price-to-sales as a valuation measure for cyclical industries like semis.

VALUATIONS FOR SEMIS ARE CLOSE TO THE TOP OF THEIR FIVE-YEAR RANGE

Source: Bloomberg Finance, L.P., as of August 31, 2019. Semiconductors represented by the PHLX Semiconductor Sector Index and the market represented by the S&P 500 Index. One cannot invest directly in an index.

More than Huawei

Semis are expected to see their sales decline by 8.5% and earnings to fall 24.9% in the Q3 reporting season. While time will tell if that comes to fruition, the group did see a top line surprise of 1.42% and a bottom-line surprise of 8.90% in Q2, showing some resiliency. An easing of tensions related to Huawei, which we did see to some extent recently, would go far to improve the negative outlook. However, some companies may still need to cut their estimates further should the Chinese economy continue to decelerate. Most importantly, semiconductors will not be immune any negative rhetoric out of China and the U.S. as trade talks are set to resume in October and optimism has increased. On the flip side, positive comments would go a long way in supporting further price appreciation.

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