IN THIS ISSUE:
Led by a relentless rally in a narrow set of large technology companies since the lateMarch shutdown trough in risk assets, the increasingly overextended U.S. equity market became highly vulnerable to a correction as the typically volatile presidential election season approached. Fears of a U.S. and European coronavirus case resurgence and renewed government-imposed restrictions to economic activity and personal mobility have offered another catalyst for profit taking, while Federal Reserve (Fed) officials' clamor for additional fiscal stimulus in the context of a political impasse around a new stimulus package only have exacerbated the adjustment lower.
Indeed, Fed Chair Powell himself has been outspoken about his belief that more fiscal stimulus (including extended unemployment benefits, eviction protections, and state and local government support) is critical for achieving the Fed's forecast for further declines in the unemployment rate from 8.4% in August to 7.6% by the end of 2020 (the unemployment rate dropped to 7.9% in September). While this has raised concerns about the outlook and about the Fed's self-confidence in its ability to steer the economy in the right direction despite massive efforts to date and promises of extended policy support into 2023, we believe that the outlook is more robustly positive than the equity-market drop and dollar appreciation of the past few weeks seem to suggest:
All in all, we believe that the September equity market swoon is a typical seasonal correction in a secular bull market driven by the new synchronized global expansion.
Drought conditions and severe wildfires in California this year have been two extreme consequences of growing water scarcity in the U.S. West. As we now enter the fourth quarter of 2020, yet another indication of this emerging challenge will be the launch of the world's first water futures market toward the end of the year. The CME Group last month announced its plans for the new futures contract, which will be based on weekly prices for California water rights per acre-foot (the volume required to cover one acre of land in one foot of water) and will allow farmers, businesses and municipalities in the state to protect against significant price swings. But while California's troubles have been among the most visible, water scarcity is still a growing challenge worldwide and remains a major long-term investment theme.
Only around 1% of the earth's water occurs in the liquid freshwater form found in rivers, lakes, streams and aquifers. And as the global population grows and becomes more prosperous, this limited freshwater supply is coming under increasing pressure. The global population is expected to grow by roughly 750 million people between 2020 and 2030, meaning more individuals consuming more discretionary items such as cars, household appliances, electronics and higher-protein diets. And this translates into more demand for natural resources—including water. According to the International Fund for Agricultural Development for example, up to 15,000 liters of water are required to produce a single kilo of grain-fed beef, with up to 3,000 liters needed to grow a kilo of rice. Electricity generation for lighting homes and offices, running industrial machinery and charging electronic devices is another major source of demand. It takes for example an estimated one liter of water to light a single 60 watt light bulb for 12 hours. Add to that the supply-side effects of global climate change, and the scope of the looming water scarcity challenge becomes clear.
As demand increases for agricultural, industrial and consumer use, the 2030 Water Resources Group – a partnership between the World Bank, the World Economic Forum and a series of multinational organizations – has projected a near 40% global shortfall in available freshwater by 2030 based on historical water productivity (Exhibit 1). And the United Nations (UN) predicts that around 50% of the world's population will be living in areas of high water stress by the same year. The key question for investors is how this gap will be closed and who will benefit as it does so.
Exhibit 1: Global Water Scarcity—A Near 40% Deficit By 2030.
Water withdrawals refers to the amount of water removed from the source, a portion of which can potentially be reused. In contrast, water consumption refers to the amount that is expended and not available for reuse. Data shows existing supply, which can be provided at 90% reliability, based on historical hydrology and infrastructure investments scheduled through 2010; net of environmental requirements.
On both the demand side and the supply side, the global water scarcity challenge varies considerably across geographic regions. And beyond the recent shortages in parts of the U.S. West, many of the poorest and fastest-growing economies of the world will be those worst affected. According to the 2030 Water Resources Group, a whopping 70% of the global increase in freshwater demand out to 2030 is projected to come from just Asia and Africa. And with more than 55% of the increase on a sector basis expected to come from agriculture, the bulk of global demand growth is likely to be relatively inelastic in the face of income headwinds from the pandemic. Demand-side solutions should therefore play a part in addressing future shortages. These include rationing measures as a means of curbing overuse, higher rates from local utilities and gains in efficiency. Indian agriculture for example is projected to account for over 10% of the global increase in water demand out to 2030, and the use of more efficient methods such as drip irrigation (over traditional and far more wasteful spray irrigation) is likely to increase as a result.
Over the longer term however, supply-side measures are likely to play a larger role in addressing the scarcity challenge. As on the demand side, global supply constraints are uneven. Seven countries accounting for just one-third of the world population control more than half of the world's freshwater resources. Four of the seven—Brazil, Canada, the U.S. and Colombia, which together account for over 30% of freshwater supply—are in the Americas, and along with Russia have per capita freshwater availability in excess of the global average (Exhibit 2). By contrast, Asia and Africa (the regions with the fastest-growing demand) as well as Europe and the Middle East have the world's lowest per capita water levels.
Exhibit 2: Freshwater Supply Varies Considerably by Geographic Region.
Two supply-side solutions in particular—wastewater treatment and desalination—should play a major role in addressing these imbalances. According to the UN Food and Agriculture Organization, of the roughly 4000 cubic kilometers of freshwater withdrawn globally every year, only 44% is consumed, with more than half turned into wastewater in the form of industrial and municipal effluent and agricultural drainage (Exhibit 3). The overwhelming majority of this wastewater ultimately remains untreated—more than 80% worldwide according to UN estimates, with the share rising to over 90% in lower-income countries. This leaves considerable scope for treatment and reuse, including in high-income countries where as much as 30% of wastewater still goes untreated. California for example has adopted potable water reuse as part of its solution to local drought conditions, with the San Diego County Water Authority expecting the technique to provide around 15% of its water supply by 2035. And beyond the use of recycled water for human consumption, higher rates of wastewater treatment would also bring a wide range of other economic benefits such as reuse in crop irrigation, apparel cleaning, heating for buildings and cooling for data centers.
Exhibit 3: Wastewater Accounts for More Than Half of Global Freshwater Withdrawals.
Another key supply-side solution is desalination—the process of removing salt and other minerals from saline water. This method has been used under varying guises for centuries, but today is usually performed through one of two broad approaches. Membrane-based techniques essentially squeeze freshwater out of saltwater by pumping it at high pressure through a semi-permeable barrier, while thermal desalination techniques distill saline water using steam tubes to heat and condense it in successive stages. Both approaches are still generally viewed as too costly for large-scale water provision. But technological improvements such as the use of thinner, more durable membranes have seen aggregate costs follow a gradual downtrend, allowing output to increase significantly over recent years. According to the UN-affiliated International Desalination Association, global desalination capacity nonetheless still accounts for only a negligible share (roughly 0.002%) of global water consumption and so has scope to increase further as costs continue to decline.
We therefore expect demand for water services to increase over the coming years, both in emerging and developed economies. This should benefit companies involved in a range of related industries such as water monitoring, wastewater treatment and liquid purification services, in addition to those that provide industrial equipment for fluid handling such as pumps, valves, filters, seals and water analysis instruments. Desalination plant developers and operators should benefit from growing adoption, alongside materials producers involved in the development of new membrane technologies. Providers of other products and services that target efficient water use should also be well-positioned. These include techniques such as drip irrigation and rainwater harvesting, piping infrastructure maintenance to reduce leaks, water-efficient appliances and water utilities that can raise rates as a means of better aligning demand with available supply.
When one of the world's largest consumers of semiconductors (China) has a falling out with the world's largest supplier of chips (U.S.), something has to give. Here are the salient numbers: As the world's semiconductor leader, the U.S. accounts for roughly 45% to 50% of the global share of semiconductor production. That is considered a commanding lead (Exhibit 4).
Exhibit 4: 2019 Global Semiconductor Sales, (Market share as a %).
On the demand side, outside the U.S., no one consumes chips like China. According to the Semiconductor Industry Association, the mainland accounts for roughly 25% of global chip demand, reflecting China's solid growth in such industries as quantum computing, artificial intelligence, electric vehicles, 5G and the like. But here's the rub: Indigenous China semiconductor production covers only 14% of its domestic demand. U.S. suppliers had long been known to fill the gap which created a web of U.S.-Sino tech dependence mutually beneficial to both parties.
But then came the tech cold war. Not unexpectedly, U.S. trade restrictions on China squeezed U.S. semiconductor earnings in a key overseas market while leaving China's digital economy deeply vulnerable to supply disruptions. Both parties have felt the pain near term. But there are long-term considerations as well.
Denied access to U.S. product, China's state-led economy is focused on building out its own indigenous supply of chips. The goal of semiconductor self-sufficiency could not only undermine the future sales of U.S. chip producers, it also runs the risk of creating new Chinese competitors that could erode the dominant market share of U.S. firms over the long-term. China hopes to have domestic suppliers meet 70% of the nation's semiconductor needs by 2025. That's an ambitious target, but the trend seems clear: China is scaling up its chip production. And if history is any guide, China's domestic production could spill over into foreign markets and further challenge the U.S. semiconductor industry.
Given the above and the growing U.S. "entity list"—a list of entities that are ineligible to receive any item subject to the Export Administration without a license—what is the potential effect to U.S.-based Semiconductor Capital Equipment (SCE) earnings? With the SCE group now down 20% in the last four weeks, a great deal of bad news may have been priced in. The current "entity list" may result in around an 8% to 10% impact to earnings power for SCE companies. Investors' concern may be that the administration does not stop and that other domestic China semiconductor manufacturers may be at risk. If this proves true, this will likely result in a new normal worldwide Wafer Fab Equipment (WFE) Street estimate of $55 billion for 2020 based on data from FactSet. This suggests only modest downside risk to the calendar year 2021 Street estimates ($58 billion) as China currently represents about $10 billion WFE demand.
Near-term weakness has the potential to offer a solid opportunity for longer-term investors to consider building portfolio positions in key tech names at reasonable valuations. The U.S. has the technological wherewithal to compete with China in chips, and, with the digitalization of the global economy in the post-pandemic world, global demand for semiconductors is expected to remain robust. The CHIPS for America Act, which would provide about $30 billion to domestic production, and the growing U.S. tech alliance with Japan and the European Union and could add favorably to the long-term outlook.
Consider staying long chips.