What a Bifurcated Internet Means for U.S. Tech Stocks

Tuesday, September 15, 2020

“Politicians are pushing past the point of possible good outcomes.”

A sucker for alliteration, I was probably always going to like this sentence purely for its word play. And just about everybody likes to punch a politician, even if it is only figuratively.

Also, I was distracted by the “macro”-implications here, including the further deterioration of the U.S.-China relationship. Big narratives are compelling.

But Jon Markman was writing about a “micro”-scenario for semiconductor equipment and special chip stocks. It’s a reminder that the world keeps on turning, no matter how much sand our “leaders” introduce into the machinery.

And he provided some practical advice — a solid signal amid a bunch of noise around markets these days. And, if you’re an investor, you are thinking about the future … you have to be.

It’s one thing to simply ruminate, another to develop a plan and actually do things to shape a future that’s to your liking. Folks who do stuff like that understand, as Jon wrote for Pivotal Point readers last Friday, “a pullback is a great buying opportunity.”

At the same time, the semiconductor space is under a unique kind of pressure, requiring a nimbler tactical approach right now. Here’s Jon…

Slowly but surely, politicians in Washington and Beijing are splitting the internet in half, and that is bad news for innovation and technology investors.

On Tuesday, the Chinese foreign minister announced new initiatives for global data security, clearly aimed at curtailing efforts by the Trump administration to isolate Chinese technology companies.

It’s too little, too late. Investors should lighten up in select technology shares.

For the better part of two years, President Trump and his advisors have been intent on killing Huawei, the giant telecommunication equipment maker. Hawks in his administration see the Chinese 5G leader as a threat to American national security. With every global installation of its next-generation wireless networks, the perceived threat grows.

In 2018, President Trump signed an executive order that forbid Huawei from selling telecom gear in the United States. A year later, placement on an entities list forced American companies to obtain a special license to sell products and services to Huawei, effectively choking off the supply of key components. The Commerce Department went one step further this past May, maneuvering so that even foreign companies could not work with the firm.

These forces have taken a major toll. Huawei, once a vibrant firm with $100 billion in global sales, is now struggling to survive.

Emboldened, the White House has broadened its attack. Using some of the same tools and rhetoric, U.S. Secretary of State Mike Pompeo has targeted other best-in-class Chinese firms like ByteDance, the parent company to TikTok, and Tencent Holdings, the maker of WeChat, which is the biggest social media platform in the Far East.

As if these Chinese firms hadn’t faced enough of an uphill battle, in August the Clean Network program was announced. It aims to block dominant Chinese firms from all internet infrastructure used by the United States and its allies. If successful, the State Department program would necessarily bifurcate the internet.

Ironically, it’s the Chinese who are now pushing the international community in the other direction. Its Global Initiative on data security calls for the development of open, evidence-based rules for networks and the supply chains that make them possible.

It’s a big role reversal for a country that has for decades manipulated the rules to advance smaller Chinese firms. Forced joint ventures often transferred intellectual property from their American and European partners.

And that’s the larger problem.

While Chinese state officials are now sounding the right notes about fairness and oversight, it’s only to protect Chinese businesses from the same hardball tactics that led to their growth. The Wall Street Journal notes that officials have accused the United States of trying to sabotage Chinese expansion.

Investors need to look past the rhetoric and weigh the likely resolution. Sadly, it’s not pretty.

The shares that were hit hardest in the decline on Tuesday were technology firms with big Chinese businesses. For example, Tesla, Inc. (Nasdaq: TSLA, Rated “C”) and Apple Inc. (Nasdaq: AAPL, Rated “B”) were down 21.1% and 6.7%, respectively.

However, there is something even more troublesome bubbling under the surface.

A bifurcated internet means two distinct silos of hardware supply chains. That’s a nightmare outcome for American semiconductor firms that are by far the market leaders in terms of innovation and sales.

Semiconductor equipment makers Applied Materials, Inc. (Nasdaq: AMAT, Rated “B-”), Lam Research Corp. (Nasdaq: LRCX, Rated “B-”) and KLA Corp. (Nasdaq; KLAC, Rated “B”) tumbled 8.7%, 9.1%, and 9.8%, respectively, on Tuesday. Specialty chip makers Micron Technology, Inc. (Nasdaq: MU, Rated “C”) and Qualcomm Inc. (Nasdaq: QCOM, Rated “C”) shed about 5% apiece.

All of these businesses have substantial Chinese sales. That business is now in peril as the market for microprocessors gets divvied up.

Analysts in the past have pointed to other scares during the prior two years and recommended new purchases. The current weakness may bring a similar market call.

If the semiconductor equipment and special chip stocks rally in the near term, investors should use that strength to close positions. Politicians are pushing past the point of possible good outcomes.

The risk today is larger than ever before now that the Chinese chip market is being forfeited.

It’s clear that the U.S.-China relationship that defined the late 20th century and the early 21st century is a thing of the past, with myriad consequences — most of them short-term negative — for many industries and companies.

And semiconductors are certainly a flashpoint. But, as Jon intimates, even though it’s “not pretty,” “bifurcation” of the internet is well short of World War III.

Will the world’s two biggest economies end up in armed conflict? That’s a fascinating question.

Right now, our focus is on more prosaic things, like preserving capital and finding opportunities as they arise in a rapidly changing world.

Best wishes,

David Dittman

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