Oil and semiconductors – interesting conflict investments

What to buy, or sell, when the US president is both provoking China with a historic visit to Taiwan and badgering semiconductor companies like Nvidia around the days of a congressional resolution on a huge aid package for US chip manufacturing?

Taiwan dominates the world's manufacturing of advanced semiconductor circuits. Depending on how you define the area, you can come up with slightly different numbers, but in terms of absolute high end, over 90% of the circuits are made in Taiwan. Companies like AMD and Nvidia, for example, don't have their own factories. Almost only Intel does these days.

20-25 years ago, Intel was the undisputed world leader in semiconductor manufacturing, while Taiwanese TSMC was just a small, insignificant upstart. However, TSMC's decision to invest in manufacturing other companies' circuits proved to be a decisive move. Increasing volumes allowed TSMC to invest in new factories at a faster pace than Intel. Over time, TSMC caught up and overtook Intel in both volume and technology, not to mention how far behind TSMC left its own customers. Now it is TSMC that is the undisputed world leader in semiconductor manufacturing. With tensions rising between China and the US, this is as worrying as Europe's dependence on Russian oil and gas - perhaps even worse. Natural gas is needed to keep Germans warm in winter and factories running since the fateful decision to phase out the country's access to reliable basic energy in the form of nuclear power. But advanced semiconductors are used in all modern tools and products, civilian and military. That is what the conflict over Taiwan is really about.

How should we position ourselves if the battle for Ukraine drags on, or if, on the contrary, Russia suddenly withdraws and accepts its loss? For Ukraine, at least, shows no signs of giving up. No, we have to recognise that there may still be a long way to go in that conflict. Russia has not even begun to use its trump card of choking off gas supplies when frozen Europeans need it most this winter or when schools and factories are due to start up again after the summer. From an investor perspective, I think we can see much higher gas and oil prices this winter, making companies like ConocoPhillips, Exxon and Chevron even more obvious choices. Among the major oil companies, Conoco has been the best investment over many different time periods with Chevron a pretty good second or third. Occidental, however, has performed very strongly in some periods, especially recently. They are already much cheaper than the market in both absolute and relative terms, with P/E Price/Earnings ratios between 6 to7 for OXY and COP. With higher oil prices that boost oil company profits together with squeeze margins for the rest of the economy, I expect many ESG-minded managers to get over their fear of black gold.

At the same time, it's likely to be a heavier autumn for cyclical industrials and slightly more expensive consumer discretionary products. Airlines and hotels in particular, may find it tough again after their brief post-Covid renaissance. Continued higher interest rates, weaker growth and more expensive fuel tend to hit airlines and hotels hard.

The battle for Ukraine is in full swing, but will there be a hot (kinetic) battle for Taiwan too? I don't think either China or the US is ready for that yet. They both realize it would be protracted and costly with no real winner. Xi JinPing may have been strengthened by the ineffective sanctions against Russia, but before he is confirmed as leader for another five years in November, he would probably prefer to sit still in the boat. After that, it may be time for China to try a small blockade of Taiwan to see how the outside world reacts. A few days is enough of a marker, which need not lead to anything more serious.

In the long term, it is very clear that China will not accept anything other than Taiwan belonging to China. It is very reminiscent of how Russia has gradually moved positions in Georgia and Crimea/Ukraine before the full-scale invasion. Just like there, many will probably eventually say that it is best that China takes Taiwan without a fight. The problem with that lies in why China would stop with Taiwan when it has thus effectively gained control of the Pacific. The rest of Asia would be left open. It's like Ukraine: if Russia had been allowed to take the country without retaliation, there would be no reason left for Putin to move on to other areas he considers Russia's. The same could be said of Taiwan: The West must sue the basin and stop any Chinese advances as early as possible. And it is precisely this attitude that could provoke China. Well, that's probably not something you need to think about until the late 2020s.

What can be considered today is how to position ourselves for a potential end to the Ukraine conflict (lower gas and oil prices?) and a Chinese signal on Taiwan. Should one buy stocks almost immediately (within ten days) in the event of a conflict outbreak, as is usually recommended? Or should one sell now ahead of what is likely to be an escalation from the Chinese side? China can hardly sit idly by when the US effectively recognises Taiwan's independence by allowing a political bigwig like Pelosi to visit the island for the first time in 25 years.

I think an excellent way to position in the tense situation could be to buy Intel. Both in the short and long term. The company is positioning itself as an American alternative to TSMC by building factories for contract manufacturing of other companies' chips. At the same time, other semiconductor companies like AMD and Nvidia could face problems from sanctions if the conflict intensifies. The transformation of Intel will take many years and cost huge investments along the way, regardless of how things go with Taiwan. Today's valuation of Intel has already taken these challenges into account, so unless management screws up completely, the outlook for Intel's stock price could be either good or very good in my opinion.

In the midst of all this, we have the risk of a policy failure from the Fed. Right now the economy is looking strong after a very strong jobs number. But non-farm payrolls NFP (US job market indicator) is a notoriously laggy and unreliable statistic that relies, among other things, on arbitrary adjustments based on trend assumptions for the economy. The NFP thus becomes pro-cyclical and adjustments to the trend component could even turn a strongly positive figure negative at annual revisions in the future. This means that even if the Fed were to pause hikes due to geopolitical concerns or slightly lower inflation data, they will, as usual, be too late to actually start cutting rates. The damage of higher rates is probably already done, but not yet visible. Such a mistake from the Fed in terms of too late rate cuts would lead to weaker economy and weaker earnings around Q4-Q1 before the Fed turns around. Until then, I therefore expect both a weak stock market and a weak dollar.

Moreover, the semiconductor industry has already shown the way with 6 consecutive weak months, which in itself is a clear signal of recession. In June, growth was 13%, five percentage points weaker than in May. Samsung, for example, has also officially stated that it is holding off on new investments. Perhaps the Fed won't turn to cuts until late 2023, just in time for the US presidential election. That leaves plenty of time to look for buying opportunities in the first half of the year.

In a world of deglobalisation and remilitarisation, as well as reduced access to microchips, many companies are finding it more difficult. Electric car manufacturers, for example, are probably something to watch out for. This is particularly true of Tesla, which is both dependent on large volumes of semiconductors and has strong ties to China in particular. Another category of companies is in the defence industry. Saab, Lockheed Martin and General Dynamics are usually winners in military conflicts and geopolitical unrest, but what about their quarterly reports if there are no chips? And what about their financing and their customers when interest rates are higher and budgets are tighter due to a weaker economy? After all, the companies are already quite expensive relative to their modest growth.

The easy part of the ongoing bear market rally is probably behind us. Tougher times now await with weaker earnings prospects, higher interest rates, higher fuel prices, reduced consumer spending and growing geopolitical unrest in both Europe and Asia. In particular, I would stay far away from airlines and put my money in the oil sector instead. But long Intel and short Tesla and AMD could also be tempting if one is prepared to take the related market risks.