Chip stocks were not immune to the volatility that rattled markets overall in 2022. But Julien Nono-Womdim, Semiconductor Analyst at TD Asset Management, tells Greg Bonnell why some investors are taking a more optimistic outlook towards the sector this year.
After a tough run, semiconductor stocks have made some solid gains to start the year. But will that performance continue? We've got a lot of tech firms out there warning of a tougher economic environment. Joining us now with more, Julien Nono-Womdim, semiconductor analyst at TD Asset Management. Julian, great to have you back on the program.
Hi, Greg. I brought a chart to illustrate that. The SOX Index is actually up 15% year to date, which is quite substantial, which is 10% outperformance relative to the S&P 500. More interestingly, however, since the lows formed in mid-October of last year, semiconductor stocks are up almost 30%, quite significant for a three-month run. I'd say what's going on is throughout last year, global PMIs began moving lower. And as it stands today, most countries in the world are at or near contractionary levels from an economic growth standpoint. And there's optimism that in the months ahead, we'll start returning to growth. And that should be constructive for the sector.
All right, so that is a-- is that a classic example of the market being a forward-looking instrument? Because you talk about the PMIs. The manufacturing managers thinking things are getting weaker. You get warnings from central banks that the economy could get soft going forward. And you get-- I got to add one more. You get warnings from big tech companies about job cuts, about cost reductions. Yet, the semis rally. Is this a forward-looking play?
It absolutely is a forward-looking play. Perhaps, let's go back to last year. 2022 semiconductor performance from an industry perspective was quite good. It's only through July Q3, Q4 where fundamentals started deteriorating. And yet, the sector was down 35% on the year. The market front ran the deterioration on the fundamentals last year. And this year, the market is trying to do the same in the opposite direction, trying to front run the good news ahead.
Now, we're in the thick of earnings season as well. I don't think we've heard from all the semi names. You'd know better than me, but what have we heard so far?
Well, so far, it's been a reflection of what the market is telling us. Fundamentals are bad. Q4 earnings were mostly in line with expectations. But Q1 is going to deteriorate. Q2 is also likely to deteriorate. This is happening across all end markets. Perhaps with the exception of automotives, there are some trends there alongside electrification and EVs that are supportive for the group. But nonetheless, fundamentals are weakening. But companies are optimistic. They think that by the second half of this year, we should see a bit of a resumption to growth and partly aided by the reopening in China. What I'd say is the earnings estimates for the sector peaked in June of 2022. And since then, we've seen a 30% contraction in earnings estimates. That is the largest estimate revision in over 10 years. And so the market is starting to look past that, and companies as well. And they remain optimistic on the future.
Is that the biggest risk here, though? The bad optimism could maybe that doesn't actually appear in the second half of the year?
That is certainly a risk. If you think about the great financial crisis, earnings estimates fell by 100%. You think about the early 2000s. Earnings estimates fell by over 60%-- close to 70%. So the market is front-running bad news. But obviously, it's a dynamic adjustment. And as we go into Q1 reporting and Q2 reporting, we'll have better colors what-- as what the next 12 months look like and the market will readjust accordingly.
OK, we're talking semiconductors. Obviously, these little chips are in a lot of the things and more and more of the things that we use every day. What about artificial intelligence? A lot of headlines are on Microsoft, their investment in ChatGPT. I always want to say GDP. [INAUDIBLE] economics reported. But ChatGPT. All of this buzz around it. What could that mean for semis?
Well, for context, ChatGPT is a chat bot, an artificial intelligence-based chat bot where people can ask questions. And they get very detailed responses. The technology has actually been around for a number of years now. But it's the first time that it is available to the general public. And I think that from a semiconductor perspective, it bodes well for the entire sector. These models that ChatGPT are based on, they require a lot of compute. And so OpenAI, which is the company that created ChatGPT, they are the first company, I believe, to have ever used more than 10,000 GPUs, which are the chips that Nvidia produces for training purposes. If you think about memory, that's another area that's going to be in high demand as you need more data to feed into the models.
Does it take 10,000 processors for that ChatGPT to talk to me like a human? Because I don't want to say I'm smarter than it, but I'm only using one brain-- one brain. [LAUGHS]
It takes a lot of compute, Greg. It certainly does. And that's historically, the semiconductor industry, believe it or not, has actually done a very bad job at forecasting a long-term growth because there are always these end markets that open up. And so in the case we're talking about chat bots, which can over time, help businesses interact with their customers, there are other applications in health care, as you and I have talked about in the past.
There are an opening avenues for semiconductors to continue to grow. And I think this is yet another example that there are going to be opportunities within the sector to benefit from these structural growth drivers.
So this is the future in the here and now. We know that cloud computing is a big, important part of the market. You think about Microsoft. And like, what do people want to know? They want to the health of the cloud. Microsoft did warn us earlier this week that, like, they're seeing some slowdown-- some caution out there among their customers. Well, what could that do for chip demand in the short term?
In the short term-- and we are starting to see it as, as I alluded to earlier-- chip demand will certainly slow down. However, there's a challenging and there's a fight between existing demand and future demand. You talked about ChatGPT. That underpins growth in the data center world, which is really what relates to cloud data center hardware. There's going to be some cyclicality.
And I think what is important for us to contextualize is that semiconductors are more analogous to industrials than they are to software. They are the lifeblood of the economy. And when the economy is contracting, demand for semiconductors goes down. When the economy is expanding, demand goes up. And that's reflected in higher CapEx spending by companies. And so in the near term, you are right that the slowdown in cloud is going to impact semiconductor demand.