A searing rally in Chinese chip stocks is facing a reckoning as investors worry intensifying tensions with the US may strangle the sector’s growth despite Beijing’s efforts to achieve self reliance. 

A FactSet gauge tracking the nation’s chip-related firms slumped more than 5% Friday, trimming the year’s advance to 15%. Advanced Micro-Fabrication Equipment Inc and the nation’s largest chip foundry, Semiconductor Manufacturing International Corp, have still surged more than 50% compared with a 4.2% gain in the onshore CSI 300 benchmark.  

The sector has been caught in the crosshairs of rising Sino-American tensions given that semiconductors power everything from smartphones to artificial intelligence and military hardware. As President Joe Biden aims to soon sign an executive order to limit investments in key high-tech sectors, investors are questioning whether Beijing’s policy push can outweigh such headwinds and allow the rally to run.

The sanctions “will require Chinese chipmakers to develop their own ecosystem, which will be quite challenging but something they will have to do”, said Roxy Wong, senior portfolio manager for Asia and Global EM equities at BNP Paribas Asset Management. “This will prompt further investments by the Chinese chipmakers to try to evolve and perhaps leapfrog the technology.” 

The US has increasingly limited the export of advanced chips to Chinese customers, also seeking to enlist key equipment makers like the Netherlands’ ASML Holding NV to join the blockade. The Biden administration is seeking to get international support during the Group of Seven summit next month and sign the measures, according to people familiar with the matter.  

The developments so far have emboldened Beijing’s self-reliance push, with authorities encouraging industry players to boost their chip-manufacturing capacities and accelerate the transition to local equipment providers. The nation is also giving some firms easier access to subsidies and more control over state-backed research. 

“The Chinese government will choose to introduce more sector-specific growth stimulus as it considers semiconductors one of the strategically important sectors for national security and economic developments,” BNP Paribas SA strategists including Jason Lui wrote in a note this week.   

The hype surrounding ChatGPT and other generative AI systems has also fuelled the gains. Shares of Cambricon Technologies Corp, a local maker of core AI processor chips, have surged more than 350% this year.  

The sector’s rally stands out as the broader market has moved sideways since the reopening trade fizzled out. A lack of fresh impetus has made investors latch onto themes to bolster gains - another reason for chip shares’ outsized moves. 

But semiconductor shares are due for a reality check as investors scrutinise earnings. While SMIC’s stock listed in Hong Kong has gained almost 40% so far in 2023, consensus estimates show its revenue may slump 22% in the first quarter from a year earlier. All that is raising concern about valuations, with the stock trading at 30 times forward estimated earnings - the highest since August 2021. 

Analysts at Jefferies Financial Group Inc wrote earlier this month that while sector-specific stimulus hopes had excited markets, there hasn’t been new policy action. 

Sentiment now appears to be shifting from earlier this month, when stocks received an immediate boost as tensions escalated. While Beijing’s announcement of a probe into Micron Technology Inc supported shares, investors are coming to the realisation that local firms lack the ability to produce advanced chips and many are loss-making.  

“The technology gap will be very difficult for Chinese chipmakers to close, especially with restricted access to global semiconductor production equipment vendors,” said Vey-Sern Ling, managing director at Union Bancaire Privee. “Throwing cash at the problem will have a very limited impact.”   

Still, the gradual recovery of China’s economy after its exit from Covid Zero is boosting restocking demand, and an expected turnaround of the global chip cycle bodes well for the sector.    

“There is still room for improvement in the localisation rate of semiconductor equipment,” said Leping Huang, an analyst at Huatai Securities Co. A combination of external factors and internal factors should “further catalyse the acceleration of domestic substitution”, he said.   

  - Bloomberg