Higher rates remain supportive of value stocks while semis look increasingly vulnerable to geopolitics

With inflationary expectations on the rise, growth stocks remain under selling pressure while cyclical/value plays continue to outperform. Although this development is well within our 2022 playbook, we remain highly vigilant of any major trend reversal such as one we saw last March when Fed’s inflation narrative turned more dovish as the buzz word ‘transitory’ came into play. However, with rising wage and rent inflation in the US showing no signs of abating, we continue to see long term rates heading higher which have historically proven supportive for the economic sensitive Japanese stock market.

This is especially so as most recent data continues to support the view that the milder Omicron variant could spell the end of the pandemic by the end of this quarter. Some reports suggest that even BOJ is looking to change its benign pricing outlook as input cost pressures are mounting and Japanese companies are increasingly facing no other choice but to pass on these higher costs to their customers. With JGB yields also on the rise, the medium-term outlook for Japanese financial firms is turning more positive and the sector has started to show notable outperformance of late.

As previously underlined, one key area of concern remains Japan’s semiconductor industry which we see being potentially disrupted at some stage this year by ever rising tensions between US and China. Last week’s news by Yomiuri that Japan and the US are working together to set up a framework that would restrict exports to China of sensitive technology deemed vital to national security did not get much attention. The report points out that the two countries along with other Western allies are working to regulate exports of technologies that may include semiconductor-making equipment, quantum cryptography and artificial intelligence.

To be sure, global capital investment in the sector remains very healthy, led by TSMC which has allocated at least another $10bn more in capital outlays this year to more than $40bn to beef up output of its chips. However, given that Chinese firms account for roughly 30% of existing order books for Japanese high tech tool makers and material suppliers we have argued that tighter export restrictions to the region is not currently priced into related shares and could provide a big negative surprise in the months to come. Indeed, recent reports suggest that despite existing export restrictions, Chinese semiconductor industry continue to grow at a rapid pace. 

According to the latest reports from various industry associations, China has now more than 350,000 firms operating in the semiconductor sector, 80% of which were registered within the last 5 years and 30% within the past 12 months, backed mostly by central and local government subsidies. Many of these firms are said to be in high-end chip design. These reports suggest that if China maintains its 30% annual growth rate over the next 3 years, it is likely to become the third largest after US and South Korea. Given the above trend, and ever-growing tensions between China and the West, we think the potential for much more draconian export restrictions could lead to big order cancelations, perhaps as soon as Q2 of this year.