Semiconductor shortage: Why more than tech investors should care

The COVID-19 pandemic has brought about many economic dislocations. One that has received considerable attention is the global shortage of semiconductor chips. This development is often framed within the context of the automotive industry and the knock-on effects of idled assembly lines and skyrocketing used car prices. But the chip shortage and the tribulations caused by it spread wider, impacting all industry sectors, regions and likely a sizable share of the world’s households.

Really bad timing

The semiconductor industry has been notorious for persistent imbalances as chip producers and consumers try to find an equilibrium between supply and demand. The current imbalance is the result of the collision between supply chain disruptions caused by economic shutdowns and an explosion in the world’s hunger for chips as the pandemic accelerated the digitisation of the global economy.

In a typical cycle, the semiconductor industry increases capacity to meet its order books as demand returns. The challenge presently facing manufacturers is that the slope of the demand curve has steepened during the pandemic, meaning chip makers are scrambling to reach an increasingly higher target. Industry executives expected inventories to be rebuilt by the end of 2021, but as the magnitude of the imbalance has come into sharper focus, optimistic estimates now call for mid-2022 at the earliest.

Given the complexity of semiconductor fabrication, additional capacity cannot simply sprout up. Since demand continues to outpace supply – and there are no major greenfield facilities coming online until late 2022 – the market for chips will become even tighter in coming months. In the interim, management teams across a host of industries face tough decisions about production prioritisation that stand to impact their revenue streams and profitability.

Two years in the making

To understand how the situation reached this point, you must revisit 2018. During that year, the industry built up inventory in anticipation of late-year demand, which ultimately did not materialise. That was followed in quick succession by the US-China trade war – which further weighed on demand – and the onset of the global pandemic. While the pandemic further quashed demand in some semiconductor end markets, it catalysed it in others. The automotive sector was the most notorious example of the former as buyers cancelled orders, while anything associated with remote work and the digitisation of the global economy exemplified the latter. When demand returned for cars and products used outside the home, order books were already full.

It is different this time

The demand for semiconductors has hit an inflection point and, for some, there is no going back as an increasing share of global economic activity occurs digitally. Remote work and developments with the world’s automotive fleet have created incredible demand for the complex chips that power cloud computing and artificial intelligence (AI). Analog chips are also essential components for autos and products and applications associated with the Internet of Things (IoT).

While the semiconductor industry scrambles to meet rising demand, it must also navigate shifts in the geopolitical and global trading environment. The chip supply chain is among the most globalised and the move toward localisation will likely have far-reaching ramifications as chip producers adapt to potentially more fragmented and siloed marketplace.

Lastly, some investors may not fully recognise the risk posed by the prevalence of analogue chips in the machinery and tools of the world’s factory floors. “If an assembly line is dependent on a $4 chip, and a few go down with no replacements in stock, production may grind to a halt, resulting in shortages of products with seemingly no relation to the semiconductor complex,” shares Fish.

An investor’s perspective

On the supply side, the current imbalance will likely create even more tailwinds for the semiconductor capital equipment makers that enable chip production. Should markets become more localised, the number of buyers for this complex machinery is expected to grow.

Given the near-term perturbations surrounding supply and demand, the hunger for analogue chips will likely continue to grow as digitisation results in ever higher levels of semiconductor content across a broad range of applications. Additionally, secular demand for the chips that power AI and cloud computing is bound to strengthen as the world moves toward a digital economy.

Finally, chip buyers must revisit the practice of ‘just-in-time’ inventory that exacerbated the current shortage. Consequently, companies especially dependent upon chips in their products or processes may need to consider transitioning to a ‘just-in-case’ inventory method.

While the nuances of the industry structure and semiconductor cycle are typically the domain of tech investors, a 21st century economy cannot operate without semiconductors, which means that further industry developments should command the attention of all financial market participants.

Shaon Baqui, Research Analyst, Janus Henderson
Denny Fish, Portfolio Manager, Janus Henderson