Chip Stocks Soaring 28% On China Optimism Risk Steep Pullback

Chip stocks have soared about 28% this year, as measured by the VanEck Vectors Semiconductor ETF (SMH), fueled largely by optimism regarding a successful U.S.-China trade deal. But chipmakers, along with other U.S. stocks with major exposure to the Chinese market, could get crushed if a trade deal falls apart or fails to meet expectations, according to some investors and analysts.

Companies with significant exposure to this potential headwind include Qualcomm Inc. (QCOM), Micron Technology Inc. (MU), Qorvo Inc. (QRVO), Broadcom Ltd. (AVGO), and Texas Instruments Inc. (TXN), which generate between 40% to 60% of their total revenues from China, per a CNBC column. Morgan Stanley highlighted other potential risks to the sector this week when the firm downgraded Micron to a sell, citing both oversupply and demand concerns.

5 Chip Stocks With Huge Exposure To China

(% Sales From China)

• Qualcomm Inc.: 65%
• Micron Technology Inc.: 57%
• Qorvo Inc.: 50%
• Broadcom Ltd.; 48%
• Texas Instruments Inc.: 43%

Source: CNBC

Eased U.S.-China trade tensions have sent shares of semiconductors soaring, driving companies such as Advanced Micro Devices Inc. (AMD) and Nvidia Corp. (NVDA) up 57% and 42% respectively. Given the optimism priced into these stocks, they are particularly vulnerable to a miss in expectations.

A Citigroup study has placed 95% odds that the US-China talks will fail to reach a "comprehensive" agreement. The same study, released in February, said there is likely to be either a "veneer" of an agreement, or talks will fall through. Others have gone as far as to call a potential U.S.-China deal a "sell signal,” per an earlier Investopedia story. Hondius Capital Management LP founder Shawn Matthews said any deal is likely to be “watered down” and would end the stock rally started at the end of 2018.

China-U.S. trade risks aren't the only force that could pull down the chip stocks. Economic Cycle Research Institute economist and co-founder Lakshman Achuthan says he expects a 20% decline in volume demand, or a ten-year low in the growth rate of demand, to weigh on semiconductors, per another Investopedia report. The market watcher indicates that even with a dovish Fed and a trade deal with China, these factors will not outweigh the fact that investors are overestimating worldwide demand for semiconductors. Achuthan’s thesis was echoed in a recent note from Morgan Stanley, which harped on Micron’s supply and demand issues. Analysts expect inventories to pressure margins at the company, per CNBC.

Risks aside, if the market perceives any U.S.-China agreement to be successful, these chip stocks could stage a sustained advance. That may assume, of course, that chip demand starts to improve.