Like the reflation which we discussed last week (specifically oil reflation), semiconductor reflation is all about inventory and supply management.
The first half (1H) of 2016 was characterized by inventory drawdowns. This was the natural outcome of the global economic downshift that hit in 2015.
But the cutback pendulum swung too far and inventories became too lean.
The 2H was driven by restocking as well as an extra boost from the new smartphones (mainly the iPhone 7).
Tight supply coupled with suddenly strong demand led to higher prices and billings.
As the chart above shows, silicon wafer (the building block for semiconductors) demand jumped as a result. More stuff was getting ordered and produced.
Demand Already Mean Reverting Lower
What happens next? Macroeconomic data for March to start showing slightly less growth.
If the flurry of activity in 2H was primarily a response to pent-up demand, then that demand has been met and activity will start to slow again. In fact, signs of that slower growth are already showing up in the latest Japanese wafer production data: Silicon wafer production has begun to ease.
Silicon is the universal common denominator for all goods production. And in that production cycle, silicon demand is early: silicon sales today reflects durable goods demand in late Q1.
This should lead to slower demand growth later in the first quarter. Growth will still be there on a year-over-year (yr/yr) basis… but a bit slower than the latest rate.
And it may slow even further heading into Q2. You see, recent growth was boosted by 3 mini-waves that are now ending.
- End of iPhone;
- End of restocking wave;
- End of Chinese New Year calendar distortion.
Each of these combined to boost global economic activity, and the tide is now shifting.
Most people don’t understand the economic impact of smartphones. Here’s one example from Taiwan. Because 30% of Taiwan’s exports are tied to smartphones, it’s a reliable gauge for the iPhone wave.
You’ll notice the export surge that begins in Q3 before starting to fade after the holidays in December.
But it won’t show up in the macro data releases until March.
Early Chinese Lunar New Year Pulled In Demand.
Chinese industrial activity is seasonal and kicks into 5th gear in the months before the Lunar New Year.
For example, steel production ramps up two months prior to the holiday as producers rush to finish and ship orders.
Iron ore imports to China surged into January… but are beginning to ease.
That’s indicative of the overall trend: the surge and then fade.
For Now… You’ll See Stronger Prices
As with oil, the outcome of supply reductions has led to firmer prices and higher billings.
But unit demand is not growing much. A little, but not much.
The result is margin pressure at a time when topline growth is a challenge.
For example, in their recent earnings release, Apple announced flat top-line (ie revenue) growth after adjusting for an extra week in their fiscal quarter this year. They had no unit growth. And that’s at a time when semiconductor prices are rising. (Apple products are essentially repackaged semiconductors.)
Apple is now squeezing semiconductor vendors (specifically TSMC and Samsung) to cut prices. And they are seeking price relief through lawsuits like the $1B one against Qualcomm.
And Apple isn’t alone – prices are going up everywhere.
Implications For U.S. Economy
Top-line growth will be tepid.
According to Factset, with 92% of S&P 500 companies reporting earnings, revenue growth y/y is 5%. Strip out Utilities and it’s closer to 3%. Net out inflation, and companies are essentially seeing no real top-line growth. It’s not enough to boost hiring and capital investment.
In fact, only 52% of S&P companies beat revenues, but 66% beat earnings-per-share (EPS). Holding back hiring and wage hikes has been central to their earnings momentum.
Consider the words of U. S. Steel CEO Mario Longhi on their recent earnings call:
“Despite lower average realized prices and shipments in 2016, our results are better as we continued to improve our product mix and cost structure.”
Can companies pass along price hikes? Two things to note in Longhi’s extended comments.
First, US Steel expects shipments to be flat in 2017 but at better prices.
Second – cost management.
It’s the same theme: firmer prices but weak volume growth.
On the one hand, firmer prices will relieve margin pressure and that means layoffs are off the table. (That’s a big difference from a few months ago when pessimism was more rampant and layoffs (ahem – reorganizations) were on the table.)
But there’s no reason to hire: demand is essentially flat.
And this assumes that companies can have their cake and eat it too.
They want to raise prices while simultaneously pushing back on their own suppliers’ costs.
In reality, inflation is a pandora’s box. It is coming from multiple directions: healthcare, energy, supplies. And interest rates are moving up. Altogether, it’s eating away at margins.
And companies pass along higher costs while holding back on salaries, then consumers will be forced to cutback.
This is stagflation at work: prices are rising, growth is flat. And consumers don’t do well under stagflation.
KEY TAKEAWAY: Recent growth has had many drivers, but most of them are fading.
Left behind is inflation – and it’s eating away at the discretionary spending for companies and households alike.
For companies, the solution is to pass along the higher costs.
For consumers, the solution is to ask for bigger raises and to cut back spending on discretionary items.
If I’m correct that a big chunk of the growth is fading, then so are the inflationary pressures. Not all – oil inflation will be around for most of the year. But the margin pressure may be peaking.
For stock investors, we may have witnessed the last good earnings season. Margin pressure in the face of minimal revenue growth will lead to a lot of downward guidance.
Editor of Moneyball Economics
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