Issue 107: Chip Stock Volatility

This Week’s Highlights

• ASML sinks, while TSMC rallies
  Dutch semiconductor equipment maker ASML mistakenly released poor results one day earlier than scheduled, leading chip stocks lower last Tuesday, though the drop in sentiment was short-lived, as ASML’s biggest customer, TSMC, reported a record Q3 on Thursday.
• Stronger September retail sales
  We’ve previously seen data suggesting parts of the economy are cooling, though it didn’t stop consumers from spending up a storm in September, leading to a consensus-beating 0.4% monthly rise in retail sales: activity that bodes well for a possible soft landing.
• US manufacturing a mixed bag
  One area of the economy that’s been cool is manufacturing, with a Philly Fed survey and broader stats on industrial production pointing to past restrictive conditions, the main culprit in America’s manufacturing contraction, finally giving way to greater optimism.

The CIO’s Take:

• Also weighing on semiconductor stocks last week was a Bloomberg report that Biden is contemplating another round of export restrictions on AI tech. Given a range of risks to chip demand, we appreciate more forgiving valuations among chipmakers in developing markets: exposure we get through active ETF allocations within EM.
• Add solid retail sales data in September to a bevy of statistics accumulating in recent weeks suggesting that the Fed may have been a little too eager with its half-point cut last month. We’ve always expected the Fed to err on the side of caution in its pace of easing, with a 25-bps cut at the next FOMC now seeming like a foregone conclusion.
• Sure, manufacturing is a smaller part of the US economy than it once was. Still, data showing managers at industrial firms feeling better about the future may play into upcoming earnings reports from individual companies, creating opportunities for stock-pickers to benefit if negative trends reverse (e.g., supposing the Fed sticks its soft landing).​​​​​​

Chip Stock Volatility

ASML earnings jumps the gun
We’re entering earnings season, and last week was a tumultuous one for an area that has been the focus of investors’ attention in recent quarters: the semiconductor sector. It began on Tuesday, when ASML—a Netherlands-based powerhouse in production of large lithography machines used by chipmakers to print silicon wafers—accidentally released earnings a day early. That error might not have been too bad, if not for the content of those results: the quarter’s bookings were half of what analysts expected, and ASML managers slashed their 2025 sales forecast.

Poor guidance drags on chip stocks
By the end of the day, ASML shares were down 16%, their biggest one-day decline since 1998, dragging US chipmakers in the Philadelphia Semiconductor Index down by 5.3%, as investors speculated ASML’s numbers might reflect a much slower recovery in demand for non-AI chips among the company’s semiconductor manufacturing clients. Fortunately, for those seeking more clarity, Thursday brought a more definitive measure of demand: third-quarter results from Taiwan Semiconductor Manufacturing Company (TSMC), which happens to be ASML’s largest customer.

TSMC posts record Q3 earnings
TSMC’s results turned out to be a complete reversal, sentiment-wise, with the world’s largest chipmaker reporting a 54% increase in net profit—rising to a record US$10 billion—exceeding analysts’ consensus forecast and sending the company’s US ADR to a record high, up by almost 10%. TSMC’s good news helped a broader basket of semiconductor shares pare losses from earlier in the week. It also serves as a useful reminder that semiconductor stocks are a diverse group, such that one’s bad news might not translate to another: a fact that creates opportunities for stock-pickers.

Take note of chip stocks’ P/E
In his comments on the company’s earnings call, TSMC’s CEO, C. C. Wei, said that AI chip “demand is real” and that he believes “it’s just the beginning.” Of course, the market is able to immediately discount and price in everything that comes after the beginning, and valuations of some chipmakers seem to reflect a pretty rosy terminal state for stocks in the sector, with industry darling NVDA selling at almost 50x forward earnings and UK-based Arm Holdings priced at nearly 100x (see below).

It’s notable to us that TSMC, even after rising 85% year-to-date, trades at a mere 24x forward earnings. Indeed, South Korean chip stocks are even more reasonably priced: The KRX Semiconductor Index—which includes the likes of Samsung Electronics and SK Hynix—trades at a modest 13x forward earnings. Thus, investors looking for bargains within a much-hyped, but still-promising sector might be well served seeking outside the developed markets.

Retail Sales Review

US consumers seem unstoppable
In addition to results from individual companies, we got some data last week hinting at the strength of the underlying US economy. On Thursday, the US Census Bureau released figures on September retail sales, which grew 0.4% for the month; that was a significant improvement over the 0.1% rise observed in August, and also higher than economists’ consensus expectation of a 0.3% gain. In other words, despite economic uncertainty—including that reflect in household sentiment surveys we’ve been citing recently—consumers keep on spending.

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Big beat on control-group sales
Results were even better looking at a metric economists call “control-group sales”, which excludes food services, autos, gas stations, and building materials, viewed as a more stable barometer for consumer spending and more closely connected to the calculations of US GDP. On that basis, retail sales powered to a 0.7% gain in September, the strongest move since a blowout month in June, and way higher than economists’ 0.3% month-over-month estimate (see below).
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For the third quarter, that put control-group sales up by 6.4% year-over-year, seemingly dispelling any notion that US consumers were slowing down going into the end of 2024. That view is borne out by a look into more granular data, with 10 of 13 categories tracked showing increases, the greatest of which was in miscellaneous stores, followed by health and personal care stores, and then grocery stores.

Job market cooling moderates
For a Fed whose super-sized September rate cut was predicated on keeping ahead of a perceived slowdown in the US economy, such data offer considerable food for thought. Labor market data released Thursday provided more evidence that slowing growth was happening at a more moderate clip, as initial jobless claims fell more than forecast, snapping back from hurricane-related effects we discussed last week. On the whole, we take figures like these as bad news for investors expecting aggressive easing, but a positive development for those of us in the soft-landing camp.

Mixed Data on Production

Philly Fed survey strengthens
The picture gets a little murkier when we turn from things like consumer spending and unemployment to the US industrial and manufacturing landscape. Last week gave economists another glimpse into this aspect of America’s economy, as the Philadelphia Fed put out its business-outlook survey, including the October manufacturing index. That benchmark surged to 10.3 from a modest reading of 1.7 in September; economists had been looking for an increase to just 3, making it a hefty positive surprise, with general activity, new orders, and shipments all rising.

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Modest cooling, but solid outlook
Importantly, survey items tracking expectations for growth over the next six months improved substantially in October, reflecting broad optimism among manufacturers about the sector’s economic outlook (i.e., greater confidence in strong demand and higher production levels in coming months). Despite some little things in the data—price indices decreased a bit, but still showed a slight inflationary trend, while the survey’s employment index dipped modestly—the numbers generally point to an economy comfortably cooling off, but a reasonably bright future.

Industrial production still weak
More sobering data out of the Fed on Thursday revealed a 0.3% drop in US industrial production for September, following a downwardly revised 0.3% increase in August. That was lower than the 0.2% decline analysts had anticipated (see below). September’s negative surprise was driven by manufacturing output, accounting for nearly four-fifths of the nation’s overall production, which slid by 0.4% for the month, much worse than economists’ expectation of a 0.1% drop. Mining performed poorly, contracting by 0.6% month-over-month, while utilities grew by 0.7% on higher energy demand.

Manufacturing isn’t the whole story
What to make of the data? For one thing, it’s worth remembering that industrial production is important to the US economy, but it’s not the whole story. Services make up well over three-quarters of the country’s GDP. So, it’s possible for manufacturing to suffer, but for the US to avoid a big downturn, overall. On top of that, the contrast between industry insiders’ expectations—increasingly bullish, from the Philly Fed surveys—and backward-looking data could be a result of the situation we’re in: restrictive monetary conditions finally giving way to more accommodative policy.