TSLombard with the note:
The chip shortage is adding to inflationary pressure and turbocharging the recovery of EastAsian exporters. Although a secular demand shift is under way–embedding semiconductors into the price of a much wider array of goods and services–integrated circuit capex and prices are still highly cyclical. The boom will be followed by disinflationary price pressure,as new production comes online. Looking beyond the cycle,as the chip supply chain splits and Moore’sLaw slows, a 20-year secular deflationary trend for semiconductors and the devices that use them is likely to halt and may even reverse.
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The semiconductor industry is highly cyclical. Periods of strong global growth raise demand, prices, and capex. The capital-intensive nature of construction, and the need for high-capacity utilization to generate an acceptable ROI, mean supply tends to lag demand, leading to long periods of under/over-capacity. The result is high cyclicality (around a secular trend) and periods of greater/lesser pricing power (Chart 2).
The current episode is one in which producers have enhanced pricing power. The demand surge has allowed semiconductor manufacturers at all levels of technology to raise prices by about 15% vs pre-pandemic levels. Higher prices are evident in both DM and EM PPI. The degree of pass-through to CPI differs by industry pricing power, with some firms choosing to absorb transitory price increases to maintain market share. Second-order price effects are large: limits on new car production contributed to the outsized rise in the used car component of April CPI.
Semiconductor price gains have further to run. Industry estimates put the worst of the shortage in Q3/Q4 2021, with supply/demand broadly in balance by Q2/22. Pricing power will remain with chip producers as demand normalizes at a higher post-pandemic level, with end-users of all types carrying much higher inventories and capacity expansion still in its early stages.
Beyond raising prices the ‘chip famine’ has politicized semiconductor production and triggered a major round of capex.TSMC alone will invest US$ 100bn over the next three years. Beijing is providing US$1.2 trn in funding for PRC firms up to 2025; we expect a classic state-led rapid expansion in China. Washington will pass the Endless Frontiers Act, providing funding to the US chip industry. Industry forecasts a35% increase in foundry capacity in the next five years with ‘only’ a 20% increase in demand. This would bring capacity utilization rates down from 95% to 82%–last seen in 2008.
Prices falling, but this cycle is different.We are at the beginning of a secular demand shift for chips,as the world becomes more interconnected, more automated and greener, each unit of GDP growth will contain a higher content of semiconductors. The change in demand will serve to limit the scope for a major cyclical decline in prices, particularly for leading-edges emiconductors. However, China’s price-insensitive efforts to expand production (for Beijing, national security trumps commercial concerns) are likely to increase price pressure at the lower end of the technology spectrum.
Taiwan from boom to bust. In a recent View, we argued that semiconductors are a commoditized product (US$ price set by global supply & demand and broadly fungible), making Taiwan a commodity exporter at risk of Dutch Disease. Demand for a USD-denominated commodity is driving up the current account surplus, causing the TWD to appreciate and making other exports less competitive. The relative strength of semiconductor production is leading to the allocation of human, capital, land (and even vaccines) resources towards the sector. Second-order growth derived from the industry is immense, too. Such is the capacity build-out under way that construction salaries rose by 25% in 2020. Reliance on semiconductors for growth will increase as demand remains high and new supply takes time to come online. When prices do eventually taper, so too will exports, capex and manufacturing employment. It took until 2020 for Korean private facilities investment and exports to recover following the memory chip cycle of 2016–18 (Chart 3 above).
Looking through the boom-bust cycle, a 20-year secular deflation tailwind may be coming to an end. Over the past two decades gains in semiconductor performance contributed to a substantial decline in quality-adjusted prices for computers, electronic products and related capital goods(the other key factor being China and FSU accession to the WTO). Most national CPI are hedonically adjusted, to account for improved quality of goods (Chart 1 above).
Moore’s Law, the observation that the number of transistors in an integrated circuit doubles about every two years, drove most of the quality-adjusted price decrease. Performance doubled every two years, with marginal increases or even falling manufacturing costs owing to offshoring of production. Moore’s Law is coming to an end; as semiconductors get smaller and denser, the technical and capital intensity needed to improve performance has increased dramatically. Technical advances are possible but the 50% decline in quality-adjusted prices from the late 1990s to the present day will not be repeated.
Politicization of production will also add costs.We think it likely that the rising economic and national security importance of semiconductors, coupled with superpower rivalry, will cause abifurcation of the current supply chain and eventually chip production into US and China blocs. Optimizing supply chains for geopolitical security is evidently less efficient than a purely market-driven process. The cost of building and operating a fab in the US is 40% greater than in China and 30% higher than in Korea or Taiwan.
Taken together, political and technology changes may end a secular deflation force, just as semiconductors become a much more important input to economic activity. Before this happens a chip price cycle, one mirrored in the economic fortunes of Taiwan and Korea, will playout over the next 3–5 years.