ASX - Semiconductors Winners And Losers At The Start Of 2023

Summary

• The year 2022 was bad for semis even though business was mostly good, which provides an important clue as to how 2023 could play out.
• Fundamentals in the semiconductor industry deteriorated as 2022 went by, but stocks did the opposite by getting better heading into 2023.
• There are a number of possible headwinds that could cause problems for semis in 2023, but a down year is still not a given.
• The most likely outcome for semis in 2023 is lower prices, but the Fed could be the wild card that shakes things up.

The year 2022 was quite the change for semiconductor stocks. The semiconductor market is projected to have expanded in 2022, but semis nonetheless underperformed, finishing with sizable losses in 2022 after three consecutive years of strong gains. In fact, what happened in 2022 can serve as a guideline as to how to position oneself with regard to semis heading into 2023. Why will be covered next.

Will the semiconductor boom be followed by a bust?

The semiconductor industry is known for being cyclical with booms followed by busts and vice versa. Few would disagree with the notion of the last several years being one of a boom for the industry. For instance, according to WSTS, the semiconductor market grew fairly sluggishly in 2010-2016 with worldwide semiconductor revenue increasing from $298.3B in 2010 to $338.9B in 2016, an increase of $40.6B or 13.6% in six years.

The market then went on a boom with worldwide semiconductor revenue increasing from $338.9B in 2016 to $555.9B in 2021, an increase of $217B or 64% in five years. The worldwide semiconductor market is projected to have expanded by 4.4% YoY to $580B in 2022. While this rate of expansion is a step down from 2021 when the market expanded by 26.2% YoY, it still amounts to a new all-time high.

However, the market is expected to contract by 4.1% YoY in 2023. It's also worth mentioning that while the overall market grew in 2022, some segments did worse than others. For instance, the analog market is projected to have led the way in 2022 with an increase of 20.8% YoY, ahead of the logic market with 14.5%. On the other hand, the memory market is predicted to decline by 12.6% YoY in 2022.

The question now is whether 2023 will be the start of a bust that could last years going by historical precedent. Opinions diverge, but many forecasts are still calling for the downturn to be a relatively shallow one with some calling for improvement starting in H2 of 2023. This is in line with GDP forecasts with some believing that the U.S. economy has a shot at avoiding a recession and if there is one, it will be a shallow one and not a deep one.

Did inventory building in China inflate semiconductor demand?

The market boomed, but there are still questions as to whether it was driven solely by real demand or whether there were other factors involved that inflated demand. This is an important issue since it could determine whether the coming downturn is shallow or deep. The rise in semiconductor demand in recent years is often attributed to the rise of EVs, HPC, IoT, AI, 5G and so on, and while they definitely helped increase demand, there is reason to believe not all the increase was due to real demand.

For starters, few would disagree that semiconductor demand got a boost from the trillions in fiscal and monetary stimulus enacted worldwide to combat the COVID-19 pandemic. This led to consumers spending more than they otherwise would have on all sort of things, including PCs and smartphones, both leading users of semiconductors. Companies too would likely have spent less in a different environment.

Another factor that is less clear is the role of geopolitical tensions. Specifically, whether the U.S.-China trade war and the resulting trade sanctions led to Chinese companies buying more chips than they really needed. For instance, Chinese semiconductor imports remained relatively flat until around mid-2017 or so when they began to spike. It could be a coincidence, but the jump in imports coincided with talk of a possible U.S.-China trade war in 2017, something that became official the following year.

There is some evidence that the increase in semiconductor imports by China was at least in part driven by the need to increase inventories to hedge against possible trade disruptions. Chinese trade patterns suggest there is a link between the pace of chip imports and the state of U.S.-China relations. For instance, imports rose in the run-up to the start of the trade war in mid-2018. This was followed by a lull in imports in early 2019 when a U.S.-China trade deal was said to be near, which would presumably put an end to the trade war. This suggests that Chinese companies reduced their buying in anticipation of a deal, which would negate the need for extra chip inventories.

However, imports rose once more when instead of a trade deal, the U.S government imposed sanctions on China's Huawei in May 2019, which could be seen as the start of the U.S.-China tech war with successive trade restrictions that continue to this day. It's not clear exactly what role U.S.-China tensions had on semiconductors, but the fact is that there is a huge difference before and after the start of the trade war / tech war. At the very least, the close to doubling of imports in a short amount of time should raise some eyebrows.

Source: China customs statistics

It's also worth mentioning that Chinese imports of semiconductors started to decline in 2022. The final numbers for 2022 have yet to be released, but imports declined by 14.4% in Jan-Nov in terms of units, although they still increased by 0.6% in terms of value due to higher prices. This could be because of a drop in real demand due to a weakening in the global economy, but less inventory building could also be a factor with a number of Chinese companies no longer able or willing to buy foreign chips.

Semis encountered divergence in 2022

The market expanded to a record high and many semiconductor companies achieved record sales and profits in 2022, but the same does not hold true for their stocks. In fact, investing in semis did not prove worthwhile for the most part in 2022. Almost all semis posted major losses, including those for whom business was better than ever.

For instance, the iShares PHLX Semiconductor ETF ( SOXX ) lost 36% heading into 2023. In comparison, the Invesco QQQ Trust ( QQQ ) lost 33% and the SPDR S&P500 ETF ( SPY ) lost 20%. Semis underperformed in 2022, unlike the preceding years when they outperformed. Still, not all semis did badly. Some fared better than others.

A looks at the individual stocks in SOXX shows this. The stocks in SOXX include Broadcom ( AVGO ), Texas Instruments ( TXN ), Nvidia ( NVDA ), Qualcomm ( QCOM ), Advanced Micro Devices ( AMD ), KLA Corp ( KLAC ), Analog Devices ( ADI ), NXP Semiconductors ( NXPI ), Lam Research ( LRCX ), Applied Materials ( AMAT ), Microchip ( MCHP ), Intel ( INTC ), Micron ( MU ), ON Semiconductor ( ON ), ASML ( ASML ), TSMC ( TSM ), Marvell ( MRVL ), Monolithic Power Systems ( MPWR ), Skyworks ( SWKS ), Teradyne ( TER ), Entegris ( ENTG ), STMicroelectronics ( STM ), Qorvo ( QRVO ), Lattice Semiconductor ( LSCC ), Wolfspeed ( WOLF ), MKS Instruments ( MKSI ), United Microelectronics Corporation ( UMC ), Silicon Laboratories ( SLAB ), ASE Technology ( ASX ) and Synaptics ( SYNA ). The table below shows the gains or losses for each stock.

Source: iShares

Which semiconductor stock gained or lost in the past year

All 30 stocks in SOXX posted losses, but ADI suffered the least with a decline of 6%. Note that ADI is one of the leading names in the analog market, which was the best-performing market segment as shown earlier. Runner-up was ON, which lost 8%. ON is also a supplier of analog chips, specifically automotive chips, which, unlike the glut in other types of chips, are still in short supply at the start of 2023.

On the other hand, many semis posted double-digit losses with some losing more than half their value in 2022. The list covers a broad spectrum of the semiconductor industry and includes names such as NVDA, AMD, MRVL, ENTG, MKSI and SYNA, which shows the extent and breadth of the decline in the sector.

However, it's worth noting that while most semis ended 2022 with big losses, many managed to cut back on their losses to end 2022 off their lows. In fact, the second half of 2022 was much better than the first half for most semis. For instance, ON, LSCC, KLAC and ASX posted big gains in H2, and Q4 in particular, narrowing their losses for 2022. Still, semis lost momentum heading into 2023 with many giving back part of their Q4 gains in December.

SOXX, for instance, gained 9% in Q4 despite losing 10% in December to bring H2 gains to plus 3%, reducing 2022 losses to 36%. The H2 comeback is even more noteworthy if changes in the semiconductor market is taken into account. The semiconductor market entered 2022 red hot with talk of a semiconductor shortage, but demand started to weaken in certain market segments, memory in particular, as the year went by. This led to downward revisions for the industry.

For example, at the start of H2, the semiconductor equipment market was expected to grow by 14.7% YoY in 2022 and by another 2.8% in 2023. But by December amid increasing signs of weakening demand for semiconductors, 2022 growth was lowered to just 5.9% YoY and the market is now forecast to shrink by 15.9% YoY in 2023. This is quite a change in six months and shows how fortunes took a turn for the worse in H2.

This deterioration in business conditions became very apparent in the second half, as reported by many semiconductor companies, which is why the outperformance by semis stands out since it coincided with quarterly numbers that were in many instances significantly worse in H2 versus H1. There are many examples, but nowhere is this more apparent than in the case of MU.

MU earned $2.34 with record revenue of $8.6B in the June quarter, but by the December quarter these numbers dropped to a loss of $0.18 and revenue of $4.1B due to the memory market. The quarterly numbers fell off a cliff in H2, yet the stock went mostly sideways in H2 with most of MU's losses occurring in H1.

This did not happen by accident. It's clear that there must have been some other factor out there that more than offset the downward pressure from disappointing earnings. While quarterly earnings deteriorated, semis got a lift from the growing perception of a potential Fed pivot or at the very least a less restrictive monetary policy by the Federal Reserve. The price action shows this.

For instance, the S&P500 rose by 5.5% and SOXX by an even more impressive 10.3% on November 10 when inflation came in lower than expected, which strengthened the case for a Fed pivot. Stocks continued to rally until hawkish comments from the Fed suggested a pivot may not be as close as thought, which caused semis to reverse course in December heading into 2023.

Investor takeaways

An article from one year ago concluded that while business was likely to be good, semis were unlikely to do as well in 2022 as in previous years due to the Fed. This turned out to be the correct assessment with many semis posting major losses even though most of them achieving record sales, as did the worldwide semiconductor market.

Heading into 2023, there are a number of potential headwinds facing the semiconductor industry, including a supply/demand imbalance, weak economic conditions, tighter monetary policy, high inflation, geopolitical/trade tensions and supply chain disruptions. Many semis also trade at high valuations, even after the drop in 2022. High valuations and falling earnings could make for a bad combination in a declining market.

While forecasts differ, the general expectation is for chip demand to deteriorate even further in 2023. Furthermore, the decline in demand is accompanied with an increase in supply with many companies proceeding with planned expansions, particularly in China with companies like SMIC breaking ground on new fabs, even after they were placed on the U.S. Entity List.

The downturn in semiconductor demand thus coincides with ongoing efforts by countries, China and the U.S. especially, to increase their share of the market. Such a state of affairs could be difficult to reconcile if chip supply goes up and demand goes down. In addition, the global economy is weakening with some forecasting a third of the planet in a recession in 2023, which does not bode well for semiconductor demand, whether it's the consumer or the enterprise with companies likely to cut back on spending in response to a weaker economy.

The outlook does not look favorable for semis in 2023, which suggests lower stock prices, but if there is one thing that 2022 showed us is that Fed policy, or the perception of it, can negate worsening fundamentals to push stocks up when they probably should have gone down. Stocks, like MU for instance, did better in H2 with horrible quarterly numbers than they did with great numbers in H1. The price action in H2 and Q4 in particular shows this clearly.

This could happen again in 2023. Quarterly earnings for most semis are likely to go down along with declining demand for semiconductors, but stocks could still rise if the Fed pivots or it is perceived to do so. Semis backed down in December, but expectations of a change in Fed policy still remains. Semis could therefore do better in 2023 than one would have suggested based on the worsening fundamentals in terms of supply and demand.

However, if the Fed does not come to the rescue as more and more started to believe in H2 2022, then semis could be among the hardest hit in 2023. Semis are facing a host of headwinds with a semiconductor glut arguably the most prominent. With this in mind, investors may want to dip their toes into semis, especially those down a lot, but remain conservative at the same time.

For instance, long/short trade pairs could be appropriate in today's environment. Something like long AMD and short INTC or vice versa could do well whether the market goes up or down as long as one outperforms and the other underperforms. Buying beaten down semis trading at low multiples also makes sense, especially if one does it for the long run and one can afford to hold on without the need for an immediate payoff.

Bottom line, the outlook for 2023 is more hazy than it was in 2022. Unlike the start of 2022 when the fundamentals were without problems, but there was little doubt as to what the Fed was about to do next, the situation heading into 2023 is pretty much the opposite. The fundamentals are no longer as solid as a year ago and they seem to be getting worse, but the Fed is more likely to help rather than hurt the stock market.

The odds still favor lower stock prices with all the issues facing semis, but what the Fed does is the wild card that could ultimately determine what happens in 2023. If the Fed gives in or leaves out the possibility of giving in to what the market wants, which is less monetary tightening, then semis can continue to outperform as they did in H2 2022 and Q4 especially. If the Fed does not, with all else set up the way it is, semis look destined to go down.

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