There is a global shortage of computer chips and the vital rare earth metals which are used in virtually all hi-tech products. Given our total reliance on technology, this could be a serious limiting factor on future economic growth. Victor Hill investigates.
A dearth of chips
The global shortage of microprocessors – computer chips – is now having a seriously detrimental impact on the recovery of the global economy from the ravages of the coronavirus pandemic. Furthermore, severe bottlenecks in the supply of rare earth metals – many of which are used in the manufacture of microprocessors – suggests that there may be further disruption of supply chains ahead. Over the last two months, several major automotive manufacturers in both Europe and the USA, including Honda (TYO:7267), Ford (NYSE:F) and JLR (owned by Tata Motors (NSE:TATAMOTORS), have been forced to halt their production lines because of outages of critical components. This could be a foretaste of things to come.
This week Ford announced that it would shut down production in two of its German factories at Cologne and Saarlouis for several weeks because of the microprocessor crunch, having already halved its Q2 2021 production target. The automotive giant will prioritise customers who have placed firm orders. The Cologne plant closed on Monday and will remain shut until 18 June. It will then shut down again from 30 June to 09 July. Around one third of the workforce will have their hours reduced. The plan is to resume full-scale production on 16 August. The Saarlouis plant will close for the rest of May and most of June. Both plants normally produce about 1,000 cars a day. Cologne makes the Ford Fiesta model as well as engines, and Saarlouis makes the Ford Focus.
Germany, Europe’s largest automotive powerhouse, is particularly affected. There the semiconductor crunch is compounded by rising metal prices and the costs associated with decarbonisation. Volkswagen (ETR:VW) recently warned that bottlenecks and supply chain blockages are affecting hundreds of components. VW has had to cut production across several locations – just as fellow German volume car producer BMW was obliged last month to shut down production of the Mini at its plant in Oxford. The German industrial federation, the BDI, said that European industry had become dangerously dependent on foreign suppliers of semiconductors. As it is, electrification means that about 40 percent of the cost of an EV resides in its battery – and most of these are produced in Asia – Korea, China and Japan being the leading centres of EV battery production. So, the proportion of a typical German car manufactured outside Europe is rising steadily. No wonder the market cap of VW, BMW and Daimler Benz combined is now less than that of Tesla.
The crunch has arisen first and foremost because the chip manufacturers themselves cut back on production in the spring of last year when the pandemic took hold and huge numbers of people in the developed world went into lockdown. They anticipated that demand would fall; but as we now know, the locked-down masses spent their days online and gorged themselves on new electronic goods, not least smartphones, tablets and PCs – hence Apple’s record sales figures. Then there was the continued rollout of 5G telecommunications networks in all advanced countries.
A freak weather event back in February centred on Texas which hit four semiconductor plants there did not help either. Another cause was the closure of the Suez Canal for six days in March by the Ever Given, one of the world’s largest container ships. But the main issue is that ownership of manufacturing capacity is concentrated in just a few countries.
Now that most of the developed world is in recovery mode – to a greater or lesser extent – the chip manufacturers are struggling to keep up with demand. It takes at least two years to build a new chip factory so there are capacity restraints. TSMC (TPE:2330) has announced a $100 billion investment in new capacity over three years. Intel (NASDAQ:INTC) of the US is investing $20 billion. Current lead times for chips can be 26 weeks and up to one year for specific varieties. Most automotive manufacturers, with their just-in-time inventory management practices, have miscalculated economic order quantities, big time. IHS Markit reckons that shortages of microprocessors cost global automotive manufacturers one million vehicles in Q1 2021 alone. Over H1 2021 that is likely to rise to 2.5 million.
And it’s not just cars. Apple (NASDAQ:AAPL) warned last week that supplies of the new iPad might be restricted. Samsung (KRX:005930) has postponed the launch of the Galaxy Note 21 smartphone. At least 169 industries from hygiene to air conditioning have already been affected by the microprocessor crunch according to Goldman Sachs.
Where chips come from
Microprocessors are the essential components of all computers which enable them to crunch and manipulate huge amounts of data at the speed of light. Though tiny, they are extremely complex products to make. According to the Semiconductor Industry Association, Europe accounts for just ten percent of global production as compared with 20 percent of global consumption. The US accounts for 36 percent of global production and South Korea for another 16 percent. Taiwan, with a population of 23 million people, accounts for the same percentage as Europe.
Last October I wrote in these pages about Nvidia’s $40 billion swoop on Arm Holdings, a world-leading UK chip designer. The closure of that sale is still in the balance. Hermann Houser, one of Arm’s founders, warned this week that Nvidia (NASDAQ:NVDA) will use the takeover to crush competition. Nvidia has already announced plans for a new microchip for servers called Grace which combines the unique technologies of both companies. This could be a threat for the likes of Amazon and Fujitsu which source from Arm and could in future become obliged to buy Nvidia’s products. The Competition and Markets Authority is investigating the deal on national security grounds after it was referred by the Digital Secretary, Oliver Dowden. Rival chip producers such as Qualcomm (NASDAQ:QCOM) and Graphcore (private – in which Mr Hauser has an indirect stake) oppose the takeover. Ultimately, the minister will decide whether to block the deal completely or to ring-fence parts of Arm’s business. A decision is expected towards the end of July.
The UK has the technological graft and the financial muscle to beef up chip production if the government moved mountains – as it did for vaccine manufacture. Mr Hauser wants HMG to drive a tie-up between Arm and Graphcore. Outside the EU, Britain is no longer as constrained by state aid rules. Newport Wafer, based on a 28-acre site west on the M4 west of Newport, is leading the way by expanding capacity.
Chip makers’ shares soar
The share prices of the major microprocessor manufacturers have risen sharply over the past 12 months – much more than the equity markets, and even better than most technology stocks. Some notable examples are Applied Materials (NASDAQ:AMAT), up nearly 180 percent, Lam Research (NASDAQ:LRCX), up 163 percent; and ASML of the Netherlands (NASDAQ:ASML), up 131 percent. ASML is unique in producing a chip using a method analogous to lithography. The world’s largest chip maker is Taiwan’s TSMC which makes the chips for Apple’s must-have iPhones. Its share price has doubled over the last year.
And yet even at these increased valuations, the major chip makers share prices are not outrageous in price-earnings terms. This week Applied Materials was trading at a P/E of around 32. And AsusTek (TPE:2357), another Taiwanese chip maker, even has a dividend yield of 3.7 percent. Investors can also get exposure to the microprocessor sector via funds. The VanEck Vectors Semiconductor UCITS ETF offers exposure to a constellation of underlying chip manufacturers.
Planet Earth will require more and more microchips as time goes by. (And the Moon and Mars will also need them in quantity in due course.) This industry is still a juvenile and its growth prospects are huge – so long as essential materials remain available.
Rare Earth Metals
The price of commodities overall is on an upward trend. Copper is now trading at around $10,000 a tonne – near to the record high recorded back in 2011. One year ago, it was trading at around $4,300. That is partly because of political developments in Peru, which is the number two copper producer in the world. The presidential front runner, socialist Pedro Castillo has promised to impose supertaxes on mining companies. Copper is used to make virtually everything from kettles to EV engines to wind turbines. Even as demand for copper explodes with the green/EV revolution, so supply could fall. Glencore (LON:GLEN), the commodities trader, processor and miner, thinks that demand for copper could double in 30 years, even though only a handful of new copper mines have come on stream in the last decade.
But the prices of the family of rare earth metals essential to producing everything from semiconductors and EV batteries to wind turbines, including lithium, nickel and cobalt, are surging even faster. Other more esoteric rare earths include lanthanum, neodymium, and dysprosium.
Some miners are looking for these elusive minerals closer to home. British Lithium and Cornish Lithium are exploring geothermal vents in offshore waters and ancient China clay deposits in the hope of finding lithium. South West England lies on a bed of lithium-rich granite which forms spectacular outcrops on Dartmoor, Bodmin Moor and St. Austell, and stretches as far as the Isles of Scilly.
Another miner, Northern Lithium, is hoping to extract lithium from hot saline brines within granite deposits in County Durham. A site on the Humber river has been proposed for the UK’s first rare earth processing plant. This would prospectively supply the proposed Britishvolt EV battery gigafactory to be located in Blyth, Northumberland. Supposedly, British-produced lithium from existing brines will produce less soil and water contamination than lithium produced elsewhere. The effective recycling of used EV batteries and rare earth magnets will also be critical.
From 2024 onwards, under the UK-EU trade deal secured at Christmas last year, British-made EV batteries will be subject to EU tariffs of 10 percent if a certain percentage of their components are not sourced domestically. If the UK is to manufacture the three million EVs a year necessary to replace retiring petrol and diesel-powered vehicles, that will require about 154,000 tonnes of lithium a year. It is not realistic that all of that could be produced at home.
The fear is that at a certain point, China, which controls 90 percent of supplies, may just halt shipments of lithium and other rare earth metals to the West. For that reason, UK officials have been meeting with their counterparts from Australia, Canada, Malawi and Tanzania in a bid to shore up supplies – an initiative reportedly code-named Project Defend. A side-deal on strategic metals could form part of the prospective UK-Australia trade deal. At the same time, the Americans are also wooing the Australians to get a slice of supplies of these precious commodities. The EU is also jostling to line up suppliers.
In Malawi, London-listed Mkango (LON:MKA) is developing a mine and refining facility for rare earth elements, though some of its output could be processed in the UK. A company called Pensana has also proposed a rare earth processing plant in Hull.
Environmental groups are reporting a marked increase in unlicensed mining for rare earth minerals in Kachin, the remote northern state of Myanmar which has a long and porous border with China. There are unsubstantiated rumours that profits from these operations are being channelled towards the military junta that seized control over the country on 01 February this year. Many of the mines are controlled by militias with links to the military. A bipartisan group of US senators has urged President Biden to place sanctions on these activities. The coup leader, General Min Aung Hlaing and other key players, are already subject to personal sanctions.
A commodities super cycle?
Many analysts and investors are talking about a commodities super cycle. Commodities tend to be cyclical because the prices of metals, agricultural crops and energy fluctuate with current supply and demand. Commodity prices are volatile. But a super cycle implies some kind of structural shift which transforms patterns of demand over the long term.
According to Fidelity International’s Tom Stevenson, there have only been four real commodity super cycles over the last 150 years[i]. The first was the US railway boom which was both cause and effect of the rapid industrialisation and urbanisation of the USA following the American Civil War (1861-65). The second was the surge in demand during the post-WWII recovery in Europe and Japan. The third, argues Mr Stevenson, was the oil shock (1973) when OPEC raised oil prices massively after the Yom Kippur War. The fourth occurred with China’s rapid economic expansion after it joined the World Trade Organisation in 2000.
So, the question is: are the steep increases in the price of copper, iron ore, nickel, zinc and other commodities some temporary phenomenon resulting from the ending of lockdowns in the pandemic end-phase? Or are they a response to the transformations in industry associated with electrification and decarbonisation? In 2019 there were just five million EVs on the world’s roads; by 2040 there will be 300 million according to Wood Mackenzie. And Mr Biden wants to rebuild America’s entire infrastructure. Massive changes are afoot.
If you believe in the super cycle hypothesis then it could be time to re-balance your portfolio in favour of commodities. You can do that by getting exposure to ETFs or by buying shares in miners and commodity traders directly. The latter option also often offers reasonable dividend income. Ironically, much as decarbonisation is the order of the day, the oil price is on an upward trajectory as the major economies return to something approaching normality. Oil majors’ share prices are responding accordingly.
Are computer chips a commodity? They have the characteristics of commodities even though the term covers a multitude of different things. Will their prices go up? Of course they will. The upshot of the microprocessor and rare earth metals crunch is that the risk of serious inflation (which I flagged recently) has ratcheted up yet further.
[i] Investors must prepare for the commodities supercycle, The Daily Telegraph, Monday, 03 May 2021. Available for subscribers at: https://www.telegraph.co.uk/business/2021/05/03/commodities-supercycle-set-make-generation-investors-rich/