January 04, 2022
Shortages of semiconductor chips are contributing to severe global supply-chain disruptions and higher consumer prices for everything from cars to toothbrushes. Those disruptions are unlikely to ease in the near term.
The pandemic has accelerated some secular trends, including remote work and cloud computing, that are likely to translate into permanent increases in chip demand. However, COVID-related pent-up spending and overordering by manufacturers to avoid production shutdowns should normalize.
From a credit perspective, we are cautious on semiconductor companies. “Bond valuations have become extremely tight, driven by excellent operational performance metrics and plentiful free cash flow,” said Vanguard senior credit analyst Scott Miles. “Looking ahead, though, chip supply is likely to eventually overshoot demand growth—the semiconductor industry is prone to boom and bust cycles. We see more value among their customers, industrial OEMs (original equipment manufacturers), many of which have proven adept at navigating both the chip shortages and inflationary pressures.”
Demand for chips initially fell sharply at the onset of the COVID-19 pandemic. Government-mandated lockdowns and dire predictions of a prolonged recession led to sharp cuts in industrial manufacturing and a buildup in chip inventories. Auto production in the United States, for example, fell by 23% in the second quarter of 2020 even though chip sales to that end market only declined by 6%.
Then the economy began to recover far more quickly than anticipated, and a surge in demand followed. Chip manufacturers struggled to respond accordingly due to both the length of the manufacturing process and the inelasticity of supply.
In addition, U.S. chip customers have felt the effect of global shipping logjams since the start of the pandemic. Chips are usually shipped by air, so the loss of belly space in commercial flights due to drastic cuts to plane travel reduced air freight capacity by as much as 75% in April 2020.
“We’re expecting a permanent increase in chip demand from PCs and other semiconductor end markets like networking equipment for remote work and learning,” said Mr. Miles. “Cloud computing apps and associated data center equipment should remain growth vectors as well. On the other hand, demand related to pent-up spending on consumer electronics is likely to prove more transitory.”
An even more worrisome development will be the winding down of widespread overordering and inventory hoarding on the part of distributors and OEMs—behavior that has aggravated chip shortages. The AlphaWise survey of chip distributors showed that inventory-building was prevalent throughout 2021, and even the latest reading shows that more than half of their customers are continuing to amass inventory. The survey results, shown in the figure below, fit with reports of double- or even triple-ordering on the part of OEMs. Such widespread overordering is a trend which is unlikely to end well for chip manufacturers.
Note: Percentages may not total 100% due to rounding.
Sources: AlphaWise and Morgan Stanley Research.
Current credit valuations of semiconductor chip manufacturers’ securities reflect supportive market trends. The future is unlikely to be as bright as 2021, however.
As chip shortages persist into 2022, they will continue to add to global inflationary pressures. Double-ordering and inventory hoarding are likely to contribute to significant oversupply when the cycle turns. So too will recent substantial capacity expansion efforts.
We see more value downstream in the securities of industrial OEMs, many of which have managed to successfully navigate supply shortages and rising input costs, including for labor. Moreover, supply constraints have enabled OEMs to raise prices to protect their margins, adjust their product mix to focus on their most profitable offerings, and improve their cash flow.
“Auto manufacturers and many other industrial OEMs are also in the midst of a cyclical upturn thanks to strong demand coming out of the pandemic,” said Vanguard credit analyst Andreas Nagstrup, “And we would expect production volumes to accelerate as the semiconductor shortages eventually normalize.”
This is an abridged version of research published recently by Vanguard Fixed Income Group.
* Includes funds advised by Wellington Management Company LLP.
Note: Data are as of September 30, 2021.
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