The semiconductor industry, known for its cyclical nature combined with robust growth potential, finds itself at a significant crossroadsCurrently, it is amid a downward cycle, compounded by the escalating restrictions imposed by the United States on Chinese technology importsAs these dynamics unfold, investment strategies that lean toward domestic alternatives emerge as a popular choice in China.

The U.SCommerce Department's Bureau of Industry and Security (BIS) rolled out a series of stringent export controls directed at China on October 7thThese measures extend beyond just direct exports, aiming to hinder China’s ability to develop advanced computing technologies and manufacture sophisticated semiconductorsMore specifically, these controls encompass products produced externally to the U.S

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but are designed to significantly tighten China's access to critical semiconductor technologies.

These regulations articulate a comprehensive ban on high-end chips, prohibiting their export to China along with any computing systems that integrate such componentsThey also impose limits on foundries that produce or develop for the Chinese marketFurthermore, the restrictions apply to the machinery utilized for manufacturing logic chips smaller than 16nm, DRAM chips at 18nm or below, and NAND chips possessing 128 layers or moreOn top of this, there are restrictions on personnel, limiting U.Snationals from working within China’s semiconductor sectorThis round of restrictions also involves revisions to the Unverified List (UVL), adding 31 new Chinese companies to its ranks.

Historically, the broadening scope of these sanctions points to a troubling precedent

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The measures have expanded from an initial focus on advanced manufacturing tools and components, now encompassing both logic and storage chips and delving into the design and production phases within the semiconductor pipelineThe controls envelop multiple facets of the industry, including chips, machinery, components, and human resources.

As a direct fallout from these disputes, the semiconductor sector has experienced a pronounced decline, with the Shen Wan semiconductor index dropping by 6.49% on October 10th alone.

From the start of the year to the present, the Shen Wan index has plummeted over 40%. The primary driver behind this downturn stems from diminishing demand for semiconductor chips amid a global economic slowdown, further exacerbated by the U.S

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sanctions that have amplified market apprehensionHowever, it’s crucial to note that industry valuations have slid to relatively low historical levels, suggesting that a significant portion of these adverse factors are already factored into stock prices, leading to a more optimistic long-term outlook.

At present, the semiconductor sector is navigating a downward cycle.

The semiconductor industry is characterized by its dual growth and cyclical natureThis growth has been evident in the rapid escalation of the global semiconductor market, which saw its value soar from $200 billion in 2000 to $300 billion in 2013—a journey that took 13 yearsCuriously, the subsequent leap of $1 trillion occurred within only four years, between 2017 and 2020, culminating in a remarkable rise to over $600 billion in just one more year by 2021.

However, history indicates that growth does not last indefinitely

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Since 1978, global semiconductors have encountered seven significant market cycles.

Presently, we find ourselves in the downward phase of this cycleA complete semiconductor cycle consists of seven stages: demand surge, shortages leading to price hikes, expanded investments, gradual capacity realization, demand reduction, oversupply, and finally, price declinesThe first four stages are marked by thriving business atmospheres, wherein companies within the semiconductor realm frequently find themselves flourishing financiallyHowever, once demand begins to shrink, the cycle shifts from prosperity to decline.

A significant contraction in orders for consumer electronics—especially smartphones and PCs—in the first half of 2022 highlights this decline

Additionally, there has been a reduction in automotive electronics sales during the second quarterWe can observe how shrinking downstream demand leads to an oversupply in the semiconductor supply chain, with major producers like ASML reporting backlog orders exceeding €33 billion in the second quarter.

With oversupply comes the inevitable price drop; however, to mitigate drastic plummeting, industry giants typically adjust their capital expenditure plansFor instance, Micron Technology announced on September 30 that their expected capital expenditure for fiscal year 2023 would drop to $8 billion, representing a 30% reduction compared to the previous yearTSMC also indicated during its Q3 earnings report that capital spending would be reduced to $36 billion for 2022.

Despite the challenging context, prospects for the semiconductor industry inventory levels indicate a potential recovery by mid-2023.

Currently, we are at a low point within the semiconductor sector; the duration of this downturn will depend heavily on the global economic recovery

However, recent insights from Taiwan Semiconductor Manufacturing Company (TSMC) offer a glimmer of hopeTSMC reported third-quarter revenues of $20.2 billion, representing an 11.4% increase from the previous quarter and a staggering 35.9% year-on-yearThis growth is primarily attributed to robust demand for the 5nm process; the gross margin stood at 60.4%, showcasing a 1.3 percentage point improvement sequentially and a 9.1 percentage point uplift year-on-year.

In terms of downstream demand, TSMC notes that while consumer electronic terminals remain subdued, data centers and automotive segments have stabilized, though adjustments appear on the horizon.

TSMC also mentioned that semiconductor supply chain inventory levels peaked in the third quarter of 2022, beginning to decrease in the fourth quarter, with expectations of several quarters needed to digest the excess

The first half of 2023 may witness a return to healthier inventory levels.

Micron Technology anticipates that the harsh pricing environment in the semiconductor industry is likely to improve starting in the second half of the fiscal year 2023, beginning in May 2023.

Moreover, market researchers within the industry forecast that reducing production across numerous NAND flash memory manufacturers will alleviate inventory pressures by the second quarter of 2023, potentially slowing further price declines during the first half of that year.

When examining the Chinese semiconductor landscape, we can categorize it broadly into three segmentsFirst, there exists a class of semiconductors affected by price cycles due to inventory levels—these have experienced the most significant declines, including drivers, microcontrollers (MCUs), and mobile chipsets

Second, semiconductors that thrive on product innovation exhibit resilience due to advancements in technology enhancing demand structures, mainly comprising storage, power, and analog chipsThe third category pertains to domestic substitution, which drives localization of technologies through equipment and material components; this type involves semiconductor equipment, Electronic Design Automation (EDA), and Central Processing Units (CPUs), which have experienced relatively subdued declines.

As the U.Sramps up sanctions against Chinese chip manufacturers, domestic substitution logic is increasingly favored for current investment strategies within China's semiconductor sector.

Data from IC Insights shows that the potential for domestic substitution remains vast

In 2021, the sales volume of semiconductors in China reached $187 billion, making it the world's largest regional market with a 32% shareWith the emergence of new consumer electronics brands and electric vehicle manufacturers, projections indicate that by 2026, China’s semiconductor sales could soar to $274 billion.

However, it is worth noting that China's capacity in semiconductor production remains relatively lowIn 2021, China's integrated circuit (IC) output accounted for a mere 16.7% of the overall market size, leaving an enormous potential for domestic substitution exceeding $150 billionBy 2026, this proportion is expected to rise to 21.2%.

Investors should capitalize on opportunities presented by companies within the semiconductor equipment sector that anticipate rising rates of localization