What Does China Recovery Mean For Semis And The Global Economy?

Why are semis important?

Semiconductors are used in a wide array of applications (data center, autos, PCs, appliances etc.) and, consequently, the demand trajectory for semis is a good proxy for the direction of the global economy.

Demand for semiconductors took a step down in May ’22 and worsened in all regions as the year progressed. As an example, worldwide PC shipments declined 29% in 4Q22, with the US PC market declining 21%, EMEA 37% and Asia-Pacific (ex. Japan) down 29%. Data center demand held up relatively better, but also softened in 4Q’22. Interestingly, as we enter 2023, we are starting to note some signs of stabilization and a potential recovery.

While consumer electronics is an important market today, most of the growth in the next 5 to 10 years is expected to come from computing & data center, wireless communications, and automotive.

The supply chain for semiconductors is very complex, which makes it hard for manufacturers to have direct control over the supply. This results in inventory imbalances that can exacerbate weak demand, creating the first-in/first-out dynamic. Apparent demand is initially much worse than end-demand as distributors work through inventory, but once inventory stabilizes, demand is aided by re-stocking.

TSMC points to demand stabilization and 2H23 recovery

TSMC (TSM) is the largest manufacturer of semiconductors with 57% foundry market share. The company reported stronger-than-feared earnings last week, but more importantly, pointed to “initial signs of demand stabilizations” and “healthy recovery in the second half of 2023”. TSMC expects revenue to decline mid- to high-single digits in 1H’23 but the full year to be a slight growth. What gives TSMC confidence in this projection? We believe it is China.

Interestingly, since pre-Covid, China declined from ~20% of TSM revenues in 2019 to only 11%. For China to return to a normalized ~20% of sales, demand would need to double in a 1-2 year time frame. This would mean 10%+ growth for the company in 1-2 years even if all other end-markets are constant.

For comparison, while China represented only 11% of TSMC sales in 2022, North America represented 68%. To put this in context, Nvidia (NVDA) management noted that while the US hyperscalers are much larger-scale than the Chinese hyperscalers, China has more consumer internet companies than the US.

What is driving re-shoring for semiconductors?

When it comes to semi design and manufacturing, no region has end-to end capabilities. Semis are designed by one company (e.g., Nvidia, AMD) in one region and fabricated by another company (e.g., TSMC) in another region. They are than assembled and distributed by third parties, which adds an incremental layer of complexity and inventory management challenges. This is one of the reasons why managing the supply of semis is difficult and inventory overbuild can exacerbate an oversupply issue.

In addition, most of the world’s fabrication (>70%) takes place in one region, Taiwan, posing significant geopolitical risk. This is the reason why governments are pushing for localization of supply chains, even though the cost may be significantly higher.

Chip design costs and fabrication have been increasing as chip sizes are declining. Designing a 5nanometer chip costs almost twice as much as the 7nanometer, and building a 5nanometer fab module costs close to double that of a 7nanometer. In addition to the cost increase due to the improved technology, localization of supply chains is adding an incremental layer of cost.

According to the semiconductor manufacturers, these cost increases will be more than offset by the benefits, and they are proceeding with very large capex plans. TSMC, for example is planning to invest $40 billion in the US for two 2 semi fab plants, Intel (INTC) will invest more than $30 billion (up to $100 billion) for two new factories, and Samsung (OTCPK:SSNLF) is planning to invest up to $200 billion (11 factories). This level of investment is very impactful for the US economy, and we expect it to provide support for industrial activity even in a slower macro environment.

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