There is a nascent ‘Cold War’ going on. It is not secret and perhaps in diplomatic circles, it is impolite to mention. But this is what happens when superpowers collide. China, by many measures is the world’s largest economy. It is the world’s largest consumer of many raw materials. China also happens to be the world’s largest producer of many manufactured goods.

The US was and probably still is the last remaining superpower.  But has been in a state of atrophy for some time. It is no secret to anyone who travels and sees the state of US infrastructure and juxtaposes this with new gleaming Chinese cities.

These shifts do not occur quickly. The rise of Chinese hegemony in so many spheres of life was a trend which began over 2 decades ago. That’s the thing with macro and megatrends. They seem trite when mentioned at a specific point in time. But when viewed with the long lens, often outline opportunities and threats.

China’s rise has been evident…if you’ve been paying attention.

In fact, it reminds me of a conversation I had, quite some time ago, with a US diplomat. I had highlighted the rise of China’s influence on the African continent. At the time, it was not seen as a massive threat to US interests. Yet, the charts from the FT below illustrate how China has since succeeded in usurping US hegemony in global trade.  After all, money makes the world go round. Trade buys influence and investment. Countries will gravitate to their most influential benefactors.

China trade chart 2000

China trade chart 2019

China has been a great imitator. For generations, Chinese producers mastered the art of ‘borrowing’ innovation from other countries and used its comparative advantage as a low cost manufacturer to produce in volume and dominate industries. It is how China become the ‘factory of the world’ and is not much different from strategies pursued by Japan and other Asian powerhouses of yesteryear.

But that narrative and strategy changed a while ago for those who bothered to notice. Slowly, China began incentivizing innovation of its own. China sought to become a technological leader in its own right. I wrote about how China surpassed the US in the number of patents registered in this piece (China: The Dragon has awoken but is the rest of the world asleep?)

In fact, as Chinese innovation becomes a competitive edge, China is likely to lean heavily of this as a means of further establishing its dominance. The schematic below from illustrates the path of intellectual property protection in China mirrors that of the US albeit around a century and a half offset. As such, China’s time to shine is coming to the fore, but the US will not recede quietly into the night.

US vs China IP chart

Enter the fray over chips.

My previous two articles discussed commodities (see Oddities with Commodities and Every cloud has a copper lining) . I have also historically written about the role China plays in commodity consumption. But commodities take on different meanings. In a digital age, microchips are ubiquitous.

They permeate everything we touch. Think of a regular day, our smartphones wake us. Our electric toothbrushes, or toasters or our cars are just a few of the many touchpoints we may or may not have thought of. All contain some sort of circuitry, which in some form requires microchips.

Now not all chips are equal. I fully acknowledge that sophistication and differentiation in microchips are as wide as they come. But for the purposes of this piece, we shall look at them as a homogenous entity. The world needs them. But microchips need semiconductors as part of their construct.

Hence, it was only a matter of time until semiconductors and microchips became yet another avenue of contention between our two hegemonic powers.

This ain’t no Fish and Chips shop:

The recent narrative from the Biden administration has been a confrontational one with China. Semiconductors are but one avenue where the US is considering ‘onshoring’ in order to decrease reliance on China.

But, we must also acknowledge that China is also seeking to decrease its reliance on the US. The chart below shows how China own consumption of semiconductors dwarves its production capacity.

China semiconductor production and consumption chart

In fact, but this measure, one could equally surmise that US rhetoric and its confrontational stance is more an offensive measure rather than a defensive measure. The chart from the Cato Institute below highlights how the production of US headquartered semiconductor firms is spread around the world. Only around 5.6% comes from China.

US semiconductor production by geography

Weaponizing the narrative:

As such, it is likely that both sides will look to steer the narrative toward matters of strategic interest and national security. That said, the impact on you and I is already being felt from a shortage in motor vehicles pushing up the prices of second hand cars and upsetting production of large manufacturers from VW to Ford – Tesla has its own worries), to a budding groundswell in electronics inflation.

Yes, some of these trends, including the chip shortage, are because of downed production due to the COVID pandemic. This was coupled with increased demand for electronic goods as work from home catalyzed equipment purchases.

Like they say, when the elephants fight, it’s the grass that gets trampled. Consumers should be wary to being that grass. Initiatives like onshoring and a global thrust toward nationalist interest and deglobalization are all potential inefficiencies and are inflationary in nature. They are worthy of concern when utilizing a long term lens rather than the short term transient inflation narrative (which I think is still a shorter term consideration, see Inflation Consternation)

So what?

Great stories do not always make great investments. Of the large semiconductor/chip producers, most are actually down around 6-10% over the last 3 months. Using a DCF model, most are also either fairly valued or even overvalued at current prices.

Major semiconductor companies

So whats the story? The purpose of a macro piece like this is to highlight the fact that the megatrend of IoT and the pervasiveness of tech in our day to day lives is not going away. Pandemics and geopolitical concerns will give rise to volatility and winners and losers.

That said, it is important to use a macro lens to highlight areas of opportunity and threat, almost like a screening tool. The next step would be to identify relative winners and losers as well as what fair value may be. This would help inform entry points for a longer term theme which will likely be persistent for the next decade or beyond.

It is useful to keep one’s eye on the bigger picture so that when cracks appear, that its not you who is ending up with the chipped china, and instead of ‘cashing in your chips’ , realize that this is just the first salvo in what is a very long poker game.



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