Chip Wars

Posted by David Nelson, CFA on July 10, 2023 in Investment Management | Leave a comment

By David Nelson, CFA

The tit for tat battle between the United States and China is raging. The US has already taken action restricting access to advanced semiconductors that could be used in artificial intelligence applications. American cloud computing, in some cases is also off limits, as access could help the Chinese circumvent A.I. restrictions by running applications in the cloud. (Click Here for my YouTube Podcast on China)

Last weekend, Beijing’s Ministry of Commerce said that three dozen metals, including gallium and germanium, critical to semiconductor manufacturing, would be subject to export controls. China currently controls 90% of the world supply. It shouldn’t be a surprise that the XI government would use any leverage it has in an ongoing battle with the West on a range of issues. This is the downside of an unwind in globalism.
 
It’s unfortunate, but you have to view it in the proper context. For the last few decades, the US approach to business relations with China was viewed through a corporate lens. On a never-ending hunt for cheap labor and better supply chain logistics, CEOs bent over backwards to make even bad deals look good.
 
U.S. corporations, big and small, embraced China with open arms, constantly looking to improve the all-important bottom line. Add the carrot of access to the Chinese consumer, company after company turned a blind eye to a rising threat that Americans are only beginning to understand.

Intellectual property theft, infiltration of our academic institutions, a rising military threat, cyber-attacks and of course, espionage so blatant that they are emboldened enough to float spy balloons across US nuclear installations and then pissed at us because we shot it down. Heard enough. I’m just getting started.

We don’t live in that world

It would be great to live in a world where we could embrace free trade and economic cooperation, even with our geopolitical adversaries. Unfortunately, we don’t live in that world. As long as President Xi is in power, it is unlikely the U.S. or the West can return to previous levels of economic cooperation and foreign policy initiatives.

Balance of power traditionalists will always attempt to return to the status quo, confident that if we keep extending a welcoming hand, we won’t get burned. Eventually, even the village idiot gets the message.

Managing the unwind is the key. Make no mistake, there are challenges that have to be addressed as we go down this path. It won’t be easy and in fact will be quite dangerous, even increasing some of the very risks we are so intent on eliminating.

Bloomberg Data

The Federal Reserve is focused on bringing inflation back to their 2% target. After ten rate hikes in 15 months, many including yours truly believe we are well on our way to achieving that goal. However, I will be the first to admit that every effort to onshore manufacturing and critical supply chains adds headwinds to the inflation fight. The above is a national security imperative but comes at a cost.

Like it or not, labor in the United States is more expensive. It will be important for the U.S. to explore other trading and logistics partnerships that can offset some of the unwind in a US-China decoupling. At a minimum, the war in Ukraine takes our eye off a much bigger problem, Taiwan. Few believe the island could survive an invasion from China, one that has been all but promised by President Xi.

Many US leaders are hoping Russia’s struggles in Ukraine after an attempted mutiny by the Wagner group, mercenaries once close to Putin, would force Xi to think twice about a costly invasion.

The United States has maintained a policy of strategic ambiguity when it comes to Taiwan. Unfortunately, there are questions as to whether Taiwan would fully prosecute a defense of the island, as many young people aren’t concerned about a Chinese takeover.

The Wall Street Journal reports the CIA believes Xi Jinping has set 2027 as the deadline for his military to be ready to take the island, home to 24 million and the world’s largest supplier of semiconductors.

COVID exposed a lot of issues in supply chain logistics. The United States is too dependent on other countries for mission critical goods and manufacturing. Taiwan has to sit at the top of that list of concerns, and every effort must be   made to accelerate current steps to onshore U.S. manufacturing of advanced semiconductors.

Finally, we need to control the narrative and the pace at which our two economies pull apart. We need to use the same diplomatic weapons they do. China, in particular Xi, is one of the best at talking a big economic partnership game but delivering very little.

China’s leaders think in terms of decades. US politicians think in terms of an election cycle. Negotiating with China is an art that demands our very best people in the room. To date, I’m not encouraged. Blinken, didn’t do a bad job negotiating with his counterparts in Beijing but of course, president Biden blows up those efforts with his Xi is a dictator comment. He’s not wrong, but it did nothing to put Xi at ease. 

Before leaving China, Secretary of Treasury Janet Yellen described talks with Chinese officials as  “direct, substantive and productive.” We’ll see in the days and weeks ahead if that translates into concrete action. 

The Good News

The good news is that corporate America is getting the message. Apple’s (AAPL) Tim Cook has turned to India as a potential alternative to their massive manufacturing footprint in China. It could take a decade for Cook to move enough in assets to make a dent in their supply chain logistics. It needs to be done at a pace in which China isn’t going to cry foul.

Tesla’s (TSLA) Elon Musk has been the most vocal about not going down this path. Look, Elon is brilliant and when he speaks, I’m all ears. But I’m not hearing a plan that makes sense in the current geopolitical backdrop.

There are alternatives. Loss of key materials, like gallium and germanium spark other sources of supply to ramp up. Just this week, Taiwan Semiconductor announced they didn’t see a direct impact from the latest Chinese restrictions. That tells me they found an alternative source.

Emperor for Life

Americans have gotten the message loud and clear. Extending the hand of friendship and cooperation is no longer a viable alternative. With Xi effectively emperor for life, few believe we will see anything different from China regardless of any efforts being made by our state department.

Power corrupts. Absolute power corrupts absolutely. Eventually, China will get the message, as their current path will not be accepted by the free world.

Unfortunately, with Beijing already planning joint military training facilities with Cuba, potentially putting Chinese troops and intelligence services just 90 miles offshore, I don’t think we have that kind of time.

*At the time of this article some funds managed by David were long AAPL and TSLA