There are plenty of points of contention between the political leaders of the two largest economies in the world, starting with the broad approach of how a country should be run.

In a meeting room at a resort hotel in China, the Chinese foreign minister literally shared a “List of U.S. Wrongdoings That Must Stop” and blasted the U.S. as the “inventor of coercive diplomacy.” Meanwhile, U.S. Deputy Secretary of State Wendy Sherman said –

“We raised concerns about human rights – namely, in Hong Kong and Tibet – freedom of the press, cybersecurity, and China’s unwillingness to allow a full investigation inside the country into the origins of COVID-19.”

Before the talks even ended, Chinese Vice Foreign Minister Xie Feng told Sherman that they were in a “stalemate.” At least the higher-ups from the U.S. and China know where everyone stands if there was any doubt.

I realize there was one big sticking point that didn’t reach the surface. That’s another thing about war, or any conflict, really.  It can often be rooted in things that go unsaid.

So we will say it today.

If a major war erupts between the U.S. and China, one very important industry that touches all of our readers directly (considering it’s indirectly how you’re reading this right now) will be a central part of the story. And it might even be the precise trigger.

Semiconductor manufacturing is squarely in the crosshairs of a major conflict brewing between the U.S. and China right now.

That might sound ominous for everyday life and the threat of war, but it also presents an opportunity to investors who are aware of the consequences.

He wants to reunify what the Communist Party believes is “traditional” China.

As we have seen in the recent past, Hong Kong was part of that process. Before the British government handed over the territory back in 1997, Beijing said it would support 50 years’ worth of autonomous rule via the “one country, two systems” structure.

However, that independence hasn’t exactly been seamless.

For instance, despite overwhelming support for pro-democratic candidates in the 2019 election, Carrie Lam – the chief executive of Hong Kong since 2017 – remains a supporter of the government in Beijing. And that is unlikely to change.

The situation in Hong Kong may also be laying the groundwork for future, similar developments elsewhere like Taiwan, a state off the coast of the Chinese mainland that has a long, complicated relationship with China’s communist rule.

The republic of Taiwan and mainland China have essentially been in conflict since the Chinese Civil War in the middle of the 20th century.

The important point to note is the present-day circumstances.

Back in January, during his New Year’s speech, Xi called for a peaceful reunification with Taiwan based on the “one country, two systems” framework, just like Hong Kong. And he also warned that Beijing would resort to force if necessary.

This is a shot across the bow.

And when I look at this from an investing point of view, it makes me notice the potential of Taiwan’s leading industries. Most people may not realize it, but Taiwan owns roughly 63% of the global semiconductor manufacturing industry’s market share.

These are the chips that power our computers, smartphones, and other electronic devices that have become so essential to everyday life and production around the world.

If China can walk in and rapidly take over the island, it will quickly gain access to innovative global technology. Taiwan Semiconductor Manufacturing (TSMC) owns about 54% of global market share, while United Microelectronics (UMC) controls another 7%.

Take a look at this chart

 

 

Taiwan Semiconductor and United Microelectronics make chips for some of the best-known companies in the industry.

Giants such as Advanced Micro Devices (AMD), Apple (AAPL), Nvidia (NVDA), Broadcom (AVGO), Marvell Technology (MRVL), and Qualcomm (QCOM), among others, all do business with Taiwan Semiconductor. Meanwhile, United Microelectronics’ clients include Infineon Technologies (IFNNY), STMicroelectronics (STM), Texas Instruments (TXN), Xilinx (XLNX), and SanDisk.

So you can see there is a lot at stake. Beijing has repeatedly said it wants to be the world superpower, supplanting the U.S. It’s in a race to gain equal footing with both America and Europe from a technology standpoint. And this situation provides the perfect prize.

By gaining access to various intellectual property blueprints, China can destroy the competition and dominate the technology industry. It can save itself years of spending on research and development by acquiring plans in rapid fashion.

So not only would it cost the country nothing to gain equal footing, but it could then turn around and produce those same products at a much cheaper cost.

That would be devastating to the companies currently doing business with Taiwan Semiconductor and United Microelectronics. They have spent years and endless amounts of money getting to the point where they are today. Their pieces of intellectual property are closely guarded because they’re vital to their businesses and successes.

But their margins are equally important. You see, in technology, much like the pharmaceutical industry, those profits fuel future growth. Yes, many executives gain wealth from boosting margins, but a lot of that money is also used to fund future research. So, if that lifeline is destroyed, it could suddenly turn very profitable businesses into breakeven or even unprofitable ones.

According to CompTIA, the leading trade association for the global information technology industry, the U.S. technology sector now employs more than 12.1 million people. That’s around 8% of the country’s workforce.

In addition, the sector made up $1.9 trillion, or 10% worth of gross domestic product (“GDP”). Loss of those jobs and revenue could have severe economic consequences.

According to Eurostat, the information and communication technology sector employs 5.6 million people (about twice the population of Arkansas) in the European Union. That’s close to 5% of the workforce. It makes up about 4% of regional GDP, or around $561 billion. The area’s three largest economies – Germany, France, and Italy – contribute the most in terms of absolute value.

However, the European Commission said that data is only through 2018 and likely incomplete. Based on the growth in technology use since then, it is likely those figures are low.

The People’s Liberation Army (“PLA”) of China conducted military drills along the southwestern and southeastern parts of the island on Tuesday. This was the second time this year that Beijing had effectively surrounded Taiwan while undertaking such operations.

China’s military brass released a communique saying that fighter jets, warships, and anti-submarine aircraft had been sent near Taiwan to carry out “joint fire assault and other drills using actual troops.” Taiwan’s military said the aircraft had violated its air-defense space.

The PLA stated that these drills were being conducted as a response to “external interference” and “provocations” – and mentioned the U.S. in the conversation.

The decades-old Taiwan Relations Act of 1979 makes the U.S. an ally of Taiwan, and it requires the U.S. to provide the country with arms.

The PLA recently said the U.S. and Taiwan have “repeatedly colluded in provocation, severely infringing upon China’s sovereignty, and severely undermining peace and stability in the Taiwan Strait.”

This response comes on the heels of a veiled threat by China state-run media outlet Global Times. Its editor, Hu Xijin, had a warning for Taiwan’s political leaders following the collapse of Afghanistan. Hu is known as a mouthpiece for the hardliners in the country’s decision-making body – or its “politburo.”

Hu recently wrote that Taiwan’s authorities must be trembling after the fall of Afghanistan’s capital, Kabul. He said they should not expect the U.S. to protect them and went on to recommend that they all order five-star red flags from China now in preparation for the eventual surrender to the PLA.

 

US Economy

 

  • The Markit PMI report showed some pullback in business activity growth this month. The deceleration was particularly sharp in services as COVID cases climbed.
  • Service hiring slowed.
  • While off the highs, growth in factory activity remains robust.
  • Supply-chain challenges are still acute.
  • Price pressures in manufacturing are hitting extreme levels, but companies are passing some of the cost increases to clients.
  • The World Economics SMI report also showed business growth slowing a bit.
  • The NY Fed’s Nowcast model forecast for Q3 GDP growth continues to trend lower.
  • The Citi Economic Surprise Index keeps declining.

 

 

  • Existing home sales remain exceptionally strong, dipping just below the 2020 summer craze in July.
  • The median price held at record levels for this time of the year.
  • Inventories remain near all-time lows.
  • Next year’s inflation figures will be calculated off the elevated base effects of this year, which could lead to a sharp drop-off in measured (year-over-year) inflation, according to Alpine Macro
  • The core PCE inflation will revert to 2%, according to Bloomberg’s survey of economists.
  • Economists and financial analysts increasingly see US monetary and fiscal policies as too stimulative.
  • The Richmond Fed’s manufacturing index tumbled in August as order growth slowed. The map below shows the Richmond Fed’s district.

 

 

  • Order backlog is easing.
  • Factories continue to boost wages at an accelerated pace.
  • New home sales are below trend on a seasonally adjusted basis.
  • Inventories of new homes have been rising.
  • Publicly-traded homebuilders increasingly control the nation’s residential construction market.
  • The median price of a new home is approaching $400k.
  • The average size of a mortgage in the US is now above $400k.
  • Outside of some weakness in aircraft parts, US durable goods orders improved further in July.
  • Capital goods orders were flat (at elevated levels), but shipments continued to march higher.
  • Mortgage applications to buy a home typically decline this time of the year. Instead, we got an increase, with the purchase index now well above 2019 levels.
  • Oxford Economics expects inflation to cool next year, driven by a gradual unwind of supply constraints and moderating demand growth.
  • Danske Bank also expects US inflation to moderate and converge with Europe next year.
  • The Kansas City Fed’s manufacturing report continues to show robust expansion in factory activity (in contrast to what we saw from the Richmond Fed).
  • Factory employment remains strong, and manufacturers expect to keep on hiring.
  • The region’s manufacturers expect the backlog of orders to ease.
  • For now, however, supplier delivery times remain at extreme levels.
  • Supplier bottlenecks have been worse in the US than in Europe because the massive US fiscal stimulus has been pumping up demand.
  • The number of anchored container ships at key West Coast ports is back near the highs.
  • Unemployment claims (excluding emergency benefits) continue to move lower.
  • Continuing claims have been holding near 2013 levels.
  • These extra benefits are about to expire, creating an income cliff.
  • Will Americans return to work after losing unemployment benefits? The employment boost in states that already terminated these programs was modest, with labor shortages persisting.
  • Adding to the income cliff will be a massive wave of evictions since Supreme Court blocked new eviction moratorium
  • Rents are surging
  • The trend of households moving out of their rentals to buy a house has petered out as house prices soared
  • Models continue to suggest that US COVID cases should be peaking. They haven’t so far.
  • The increases in new daily cases are moderating.

 

COVID Update

 

COVID cases:

 

 

Hospitalizations:

 

 

Consumer comfort with various “going out” activities:

 

 

The Fed

 

Federal Reserve policymakers increasingly look as confused as everyone else as they move toward tapering the economy off so much stimulus. Samuel Rines of Avalaon Advisors says this raises the odds of a damaging policy error.

Key Points:

  • Dallas Fed President Kaplan, who has strongly pushed for tapering, said recently the COVID delta variant’s impact might alter his view.
  • On the other hand, St. Louis Fed President Bullard flatly dismisses COVID risk and is insisting on a quick taper timeline.
  • Some kind of taper seems likely before year-end, unless delta has more economic impact than presently seems likely.
  • Tapering the asset purchases and raising interest rates are two different decisions that may not go together.

Tapering isn’t an either/or condition. The Fed can set its own pace, and a slow-enough taper might be functionally indistinguishable from no taper at all. That could be the compromise reached in whatever intra-Fed discussions are presently occurring.

 

Market Data

 

  • US shares continue to outperform the rest of the world.
  • S&P 500 median short interest is now at the lows not seen in two decades.
  • The S&P 500 rallied to within 1% of its high last week, but the McClellan Summation Index and Net % of New Highs – New Lows have both moved into negative territory. This has been a poor combination for stocks since 1928.
  • Earnings revisions have diverged from the Citi Economic Surprise Index.

 

 

  • Goldman sees the S&P 500 EPS growth stalling next year.
  • Volatility tends to pick up into September.
  • The market expects inflation to decline over the long term, which is one reason bond yields remain depressed, according to BCA Research.

Margin debt is off the charts – I’ve circled the March 2000 and October 2007 margin debt peaks. Comparatively, there has never been a period in history with this degree of leveraged speculation.

 

 

Thought of the Week

 

Spread love everywhere you go. Let no one ever come to you without leaving happier. -Mother Teresa

 

Pictures of the Week

 

 

 

 

All content is the opinion of Brian J. Decker