Key points:
- Geopolitical tensions have escalated as the US seeks to restrict China’s access more broadly to leading edge technology.
- Antipodes is considering global vulnerabilities should China choose to retaliate.
- The QE-led/long duration regime is transitioning to a regime that will focus on fiscal stimulus around decarbonisation, infrastructure and security to support economic activity.
- Earnings downgrades and flows are lagging extremely weak sentiment – yes uncertainty is high, but opportunities exist – see what Antipodes has been buying over the last six months.
The global technology arms race
It’s fair to say geopolitics is the most fraught it’s been in the last two decades.
Last month we wrote about the battle over energy between Russia and Europe, but Nancy Pelosi’s recent visit to Taiwan has set the US and China on a pathway of competitive escalation.
Semiconductors and tech independence play a critical role in US/China relations and this cannot be resolved quickly given both countries are dependent on Taiwan – or specifically Taiwan Semiconductor Manufacturing Company (TSMC) – for the manufacture of leading-edge chips.
For some time now the US has prevented a small number of Chinese firms from accessing US designed semiconductors and the equipment to make these chips where it was assumed this technology was being used for military purposes. As tensions between the two global superpowers soured further, we noted the tail risk was how far the US would push to more broadly limit China’s ability to innovate.
The US has indeed now taken a further step – introducing sweeping new controls that can limit exports to China of critical technology used to manufacture semiconductors.
Here’s what the US Department of Commerce said in an announcement regarding the move.
“The Department of Commerce’s Bureau of Industry and Security (BIS) is implementing a series of targeted updates to its export controls as part of BIS’s ongoing efforts to protect U.S. national security and foreign policy interests. These updates will restrict the People’s Republic of China’s (PRC’s) ability to both purchase and manufacture certain high-end chips.”
The details of the new controls show the US is targeting GPU, CPU and DRAM (memory) chips designed in the last five years and the equipment to make these chips, as well as NAND (memory) chips designed over the last three years. There are also specific rules limiting China’s ability to import certain AI chips widely used in datacenters and critical to many modern consumer applications.
While this policy stops short of a blanket ban, the goal is to restrict China’s access to chips and other technology related to advanced AI and super-computing as these have military applications.
What are the consequences of this move?
Most leading-edge semiconductor chips essential for high performance computing are designed by US or European companies such as Nvidia, AMD, Broadcom, Marvell, Intel but the chips are not necessarily manufactured by these companies.
In fact, at the leading-edge these semiconductor chips are almost entirely manufactured by TSMC.
TSMC has actively retained its leading-edge chip capacity at home in Taiwan, a strategy referred to as the “silicon shield”. But what’s interesting here is that more than half of the equipment used to manufacture globally critical chips comes from the US, with the rest from Europe and Japan.
If Europe and Japan choose to follow the US’ lead, it places China in an extremely challenging position. Inability to access chips and furthermore the equipment used to manufacture these chips will meaningfully hamstring not only China’s ability to keep up with tech developments in the West, but also hinder China’s capacity to develop tech independence.
At first blush the development of Chinese hyperscalers such as Tencent, Alibaba and Baidu could be impacted as the bulk of datacentre spend is AI-centric even for current consumer use around content creation, search and natural language programming. Chinese EVs may also see progress curbed relative to Western peers as ADAS chips (advanced driver assistance systems) could be affected. At this stage restrictions on handset chips appears unlikely given the limited crossover with military applications. The language framing these restrictions, which are some of the most comprehensive we’ve seen to date, suggests these restrictions could be part of a rolling series.
Much remains up in the air.
How rigorously will the US enforce these license approvals? Will Europe and Japan follow suit? How might the US expand export restrictions or worse initiate bans? Will China retaliate, and on a longer-term basis can China develop this technology internally?
China could choose to respond in a targeted fashion directed at high profile US brands with large profit pools in China such as Apple, Tesla, Nike and Estee Lauder amongst others.
China could limit US access to strategic markets that it dominates such as rare earths in the EV battery supply chain.
If the US were to escalate further via an embargo on all investment in China, it would be an extremely negative outcome not just for China but for the global economy and asset markets.
At this stage we still consider a Taiwan “hot war” scenario relatively remote given the US and China’s co-dependence on Taiwan, or should we say TSMC. For now, China and the US are critically aligned in maintaining a stable Taiwan for the sake of their respective economic stability.
Turning to the stock market
With regards to the escalating tensions between the US and China, we think it’s critical asset mangers monitor developments closely, and the team is considering global vulnerabilities should China choose to retaliate.
When it comes to the broader macroeconomic environment, Stagflation (high inflation combined with lower economic growth) remains our base case, and with a mild recession as opposed to a global hard landing, as China has the potential to loosen even as the West is tightening.
The US economy, however, bears close watching as the risk of a “hard landing” is rising – that the Fed over-tightens to control inflation and in doing so drags the US into a deeper recession.
The QE-led growth/long duration regime that dominated the post 2008 investing period is transitioning to a regime that will see policy makers lean on fiscal stimulus to prop up economic activity. In the near term this stimulus will focus on the cost-of-living crisis (as already seen in the UK and Europe), but over the longer term it will focus on investment around decarbonisation, infrastructure and security (defence and supply chains).
The US’ Inflation Reduction Act is a great example of this trend. It supports $370b worth of investment in energy security and climate change with almost one-quarter of the programme dedicated to re-shoring solar, wind and battery production in the US. Our portfolio is well positioned for these investment trends.
The year so far has been very challenging for global equities. Economic data is rapidly weakening, consensus estimates on our analysis are broadly still too high and equity inflows have been slow to reverse.
Despite this, opportunities exist.
With the high degree of uncertainty around inflation and global economic activity we have been lifting the defensive exposure of our portfolio via healthcare, attractively priced platform businesses and consumer defensives, while tapering our exposure to the more cyclical/economically sensitive parts of the market as the risk of a hard landing has risen.
Here are some examples of recent portfolio additions*.
- Merck (NYSE: MRK): lower drug pricing risk and manageable patent risk relative to peers, and a diversified earnings stream from long duration businesses including vaccines and animal health.
- Gilead (NASDAQ: GILD): HIV patent cliff pushed out while new treatments are developed to extend dominance, and an under-appreciated pipeline.
- SAP (NYSE: SAP) and Oracle (NYSE: ORCL): dominate the ERP/enterprise resource planning market (general ledger and accounting software) where transitioning this mission-critical software to the cloud has become a priority in our post-COVID hybrid work environment, and this transition is continuing in even a tougher economic environment.
- Diageo (LON: DGE): leading spirits business with 5% share of total alcohol consumption globally that is taking market share in categories that are growing, and is facing lower inflationary pressures than other defensive parts of the market such as consumer staples.
*Illustrative only and not a recommendation to buy or sell any particular security
By the Antipodes Investment Team