Chip Bulls With `Fairy Dust' Optimism Absorb Another Body Blow

(Bloomberg) -- Perhaps no industry has more at stake than semiconductors in the China-U.S. trade war. For bulls who seem hell bent on ignoring their vulnerability to the ongoing rift, faith keeps getting put to the test.

Broadcom Inc. gave investors a taste of a worst-case scenario late Thursday, chopping $2 billion off its annual sales forecast. Chief Executive Officer Hock Tan told investors the company is suffering from a "very, very sharp and rapid contraction" as a result of the trade uncertainty and U.S. ban on sales to Huawei Technologies, one of Broadcom’s biggest customers.

Chipmakers fell Friday, with the Philadelphia semiconductor index closing with a loss of 2.6%. And yet, while Broadcom added to a drumbeat of bad news that drove the sector to its worst monthly decline in a decade in May, the industry is outperforming nearly every other group since U.S. stocks bottomed last year. The 30-company gauge is up 27% since Christmas Eve.

"The market is pricing in a deal and that these problems will go away" but that’s a “fairy dust” scenario, said Gus Richard, an analyst with Northland Securities Inc. "Clearly there is some risk factored into the market, but you could easily have another 20% to 30% pullback if the tariffs get slapped on and stay through August."

Another sign that the industry has yet to price in the trade risk is that analysts have been slow in lowering their estimates. Since the U.S.-China trade spat escalated in May, analysts have cut their forecasts at a rate that’s half the pace seen for the broad market.

Second-quarter profits will drop 31.7% from a year ago, the latest analyst estimates compiled by Bloomberg showed. That’s not far from the 30.6% decline expected in early May.

Either analysts are having a hard time quantifying the risk or they’re not taking it seriously. Whatever the case, the reluctance sets up the market for potential shocks such as the one that sent Broadcom shares falling 5.6% on Friday.

The trade dispute with China threatens a worldwide electronics supply chain where the country not only serves as one of the biggest end markets but also a major manufacturing hub. As the world’s largest consumer of semiconductors, China accounts for more than half of the $470 billion industry.

With so much at stake, investors haven’t given up on chipmakers. They’ve been betting that slumping demand is poised to revive and China will be forced into a settlement because it’s dependent on American-made components, according to Mark Newman, an analyst at Bernstein.

One reason stocks may be pricing in a quick fix is that we’re in a "headline driven market," according to Michael Antonelli, managing director and market strategist at Robert W. Baird & Co.

"The market doesn’t know what to price given that one tweet changes everything," Antonelli said in an interview.

Even if there’s a quick resolution, the idea that things will return to normal is naïve, according to New Street Research analyst Pierre Ferragu. U.S chipmakers may still be at risk of losing market share in China as the blacklisting of Huawei has prompted Chinese companies to focus the attention on reducing their dependence, he said.

“China would get better at designing and manufacturing chips three times faster if they didn’t have access to U.S. technology,’’ Ferragu said in a note to clients. “Survival is a great motivation factor.”

To contact the reporters on this story: Jeran Wittenstein in San Francisco at jwittenstei1@bloomberg.net;Ian King in San Francisco at ianking@bloomberg.net

To contact the editors responsible for this story: Catherine Larkin at clarkin4@bloomberg.net, Chris Nagi, Lu Wang

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