Semiconductor Volatility Is Back: What’s Next?

Semiconductor Volatility Is Back: What’s Next?
Tactical Allocation Channel

By John Patrick Lee, CFA, VanEck Associate Product Manager

After a strong start to the year, semiconductor stocks have recently hit a rough patch. The storylines that helped to drive performance have become painful sources of concern. At the beginning of the year, positive sentiment around U.S./China trade relations helped to boost semiconductor stocks. Since early May, trade war worries have returned to the forefront for investors, with semiconductor companies paying the price.

Semiconductor Revenues Rely on China Growth and Trade

Semiconductor companies generate a significant portion of their revenues by selling their products to Chinese companies and consumers. Based on a geographical analysis of the revenues generated by constituents of the MVIS semiconductor index, over 30% of index revenues come from China, compared to approximately 21% from the U.S., as of April 30, 2019.

Semiconductor Stocks Depend on Chinese Revenues

Source: Bloomberg, Factset. Data as of 4/30/2019.

Throughout the latter half of 2018, semiconductor stock prices fell as the U.S. and China ratcheted up trade war tensions, imposing heavy tariffs on raw materials and services involved in the global semiconductor supply chain. These tariffs were imposed by both sides, and semiconductor stock prices suffered as a result. In December of 2018, the two countries declared a temporary truce to de-escalate tensions.

Since then, the countries have engaged in multiple rounds of trade talks with the aim of securing a long-term deal favorable to both. Chipmakers rallied to start the year on the consensus that trade relations were moving towards normalization. However, newly escalating tensions have led to more volatility in recent weeks and a retreat from multi-year highs.

Separately, the Chinese government has been proactively supporting economic growth through a variety of monetary and fiscal policies, and global index providers have begun including onshore Chinese equities in benchmarks. These have also been positive developments for companies with heavy exposure to China.

Ultimately, a healthy trading relationship between the U.S. and China benefits semiconductor companies with a sizable revenue exposure to the Chinese economy. It’s important to note that China remains a key risk for semiconductors, whether that stems from a breakdown in trade relations, or a slowdown in the Chinese economy.

Qualcomm’s Moat Under Pressure

Generally speaking, the semiconductor industry is heavily invested in researching and developing new technologies. After a company develops a new technology, the company typically owns the patent, which means it may effectively box out competitors from using or leveraging the technology in their own products. This has historically lead to individual companies having a distinct, sustainable competitive advantage over others within the industry—in other words, a moat.

Moats are a defining characteristic of the semiconductor industry. On a weighted average basis, as of April 30, 2019, over 80% of the MVIS® US Listed Semiconductor 25 Index have either a Wide or Narrow Moat rating, according to Morningstar.1

Qualcomm has had a number of recent high-profile developments that have directly affected the company’s sustainable competitive advantage (both positively and negatively). Qualcomm recently settled a hard-fought lawsuit that spanned over two years against Apple.2 The litigation centered on Apple’s use of Qualcomm’s smartphone processors and modems, and the royalties that Apple would pay to Qualcomm for the use of the underlying technology. After the settlement announcement, Qualcomm’s stock rallied 56%, from $57.18 on April 15 to $89.29 on May 3, as investors saw the settlement as an affirmation of its moat in relation to Apple’s iPhone revenue.

Nearly one month after the settlement deal was announced, a Federal judge sided with the Federal Trade Commission (FTC) in its antitrust suit against Qualcomm.3 This may directly affect revenues from its patent-licensing business, which is the company’s biggest source of profits. While the terms of the Apple settlement are expected to be honored, the ruling is a direct threat to the sustainability of Qualcomm’s competitive advantage going forward. Qualcomm’s stock price has fallen roughly 26% since May 3 to $65.37 as of May 28.

While the FTC ruling is specific to Qualcomm, the ruling may potentially affect other chipmakers positively. Qualcomm has effectively restricted competing chip makers from using its technology, but under the new ruling, Qualcomm would be forced to license its intellectual property to competing firms.

Basket Approach Provides Diversified Exposure in Unclear Times

The outlook for semiconductors is heavily dependent on a healthy U.S./China trading relationship and the ability for these companies to leverage innovations by turning them into long-term profits. As it stands, a disruption in either of these key areas could have major repercussions for revenues and profitability. Many analysts view the semiconductor sector as a leading indicator and a forward-looking measure of the health of the global economy. Hence, a breakdown in broad market sentiment during the last few weeks has led to a sharp increase in volatility in these stocks, with some affected more than others.

A basket approach allows investors to express a view on a specific sector of the economy, without having to know which specific stock will outperform over the future. VanEck Vectors® Semiconductor ETF (SMH) tracks the MVIS US Listed Semiconductor 25 Index. This ETF invests in approximately 25 of the largest and most liquid U.S.-listed semiconductor companies.

Important Disclosures

1. Source: Morningstar as of 4/30/2019.

2. Source: The New York Times, Apple and Qualcomm Settle All Disputes Worldwide, 4/16/19.

3. Source: The Wall Street Journal, Qualcomm’s Practices Violate Antitrust Law, Judge Rules, 5/22/19.

This is not an offer to buy or sell, or a solicitation of any offer to buy or sell any of the securities mentioned herein. The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. Certain statements contained herein may constitute projections, forecasts and other forward looking statements, which do not reflect actual results. Information provided by third-party sources are believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as of the date of this communication and are subject to change without notice. The information herein represents the opinion of the author(s), but not necessarily those of VanEck.

Indices are unmanaged and are not securities in which an investment can be made. Index returns do not reflect a deduction for fees & expenses. Certain indices may take into account withholding taxes.

Diversification does not assure a profit nor protect against loss.

MVIS® US Listed Semiconductor 25 Index is the exclusive property of MV Index Solutions GmbH (a wholly owned subsidiary of the Adviser), which has contracted with Solactive AG to maintain and calculate the Index. Solactive AG uses its best efforts to ensure that the Index is calculated correctly. Irrespective of its obligations towards MV Index Solutions GmbH, Solactive AG has no obligation to point out errors in the Index to third parties. The VanEck Vectors Semiconductor ETF is not sponsored, endorsed, sold or promoted by MV Index Solutions GmbH and MV Index Solutions GmbH makes no representation regarding the advisability of investing in the Fund.

An investment in the VanEck Vectors® Semiconductor ETF (SMH®) may be subject to risks which include, among others, investing in the semiconductor industry, equity securities, information technology sector, foreign securities, foreign currency, depositary receipts, medium-capitalization companies, issuer-specific changes, market, operational, index tracking, authorized participant concentration, no guarantee of active trading market, trading issues, passive management, fund shares trading, premium/discount risk and liquidity of fund shares, non-diversified, and concentration risks, all of which may adversely affect the Fund. Foreign investments are subject to risks, which include changes in economic and political conditions, foreign currency fluctuations, changes in foreign regulations, and changes in currency exchange rates which may negatively impact the Fund’s returns. Medium-capitalization companies may be subject to elevated risks.

Fund shares are not individually redeemable and will be issued and redeemed at their Net Asset Value (NAV) only through certain authorized broker-dealers in large, specified blocks of shares called “creation units” and otherwise can be bought and sold only through exchange trading. Shares may trade at a premium or discount to their NAV in the secondary market. You will incur brokerage expenses when trading fund shares in the secondary market. Past performance is no guarantee of future results.

Returns for actual fund investments may differ from what is shown because of differences in timing, the amount invested, and fees and expenses.

Investing involves substantial risk and high volatility, including possible loss of principal. An investor should consider the investment objective, risks, charges and expenses of a Fund carefully before investing. To obtain a prospectus and summary prospectus, which contains this and other information, call 800.826.2333 or visit vaneck.com. Please read the prospectus and summary prospectus carefully before investing.

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