It shouldn't come as a surprise that a California-based chip manufacturer recently joined the likes of Apple and Microsoft in an exclusive club of companies with a market capitalization of more than US$1 trillion. This California-based chip manufacturer designs the hard-to-get modified graphics chips (GPUs) that power the latest generation of artificial intelligence (AI). In fact, the unexpected rally US stocks have enjoyed this year has been attributed to a handful of technology companies (including this California-based chip manufacturer) that are expected to benefit most from the sudden popularity of so-called generative AI as an investment theme.

Investing is heavily influenced by big structural themes. The successful integration of macro and micro analysis may be one of the biggest opportunities over the next few years. Here are five long-term themes that affect the chip industry:

1. Rapid advances

Chipmakers have kept up a relentless pace of innovation that other industries can only dream about. No other segment of the economy has progressed at the rate the chip industry has achieved.

For more than half a century, the industry followed Moore's Law, which states that the number of transistors on a microchip – a rough gauge of processing power – would double every two years, while costs would halve. To fit the billions of transistors onto a chip the size of your fingernail, each one must be roughly the size of a coronavirus. Making them requires a level of precision that's unparalleled.

While Moore's Law is no longer true, chip makers are still expected to innovate at a pace that’s unheard of elsewhere – rolling out a new set of products every couple of years, a tool that's even more advanced, or materials that are well-suited to the next manufacturing process.

2. Concentration of know-how

The industry has developed into an extensive ecosystem of firms that produce the software, the ultra-specialized materials, the precision-machine tools, along with the knowhow to bring all these different things together in manufacturing to a high level of precision and accuracy. This supply chain stretches from Europe to the United States to parts of East Asia, such as Japan and Taiwan, where you have a few companies that have specialized in just one facet of this production process. Every aspect of the chip-supply chain has roughly comparable levels of concentration in the hands of just a few firms.

The barriers to entry are high because there's all sorts of unique types of knowledge, tacit knowledge, or implicit knowledge, that's built up within companies, that’s very hard to learn or replicate. When you look at advanced processor chips, some 90% are produced in Taiwan by one company.

3. Product specialism

Microchips are highly specialized. They are designed and built to meet specific needs and, at the cutting edge of the industry, a chip that's designed for one purpose cannot be used for something else. For example, you would be able to take an iPhone chip and plug it into a computer, right? Of course not.

The industry has been producing more chips every year since 2020. But the chip shortage that the auto industry has faced is due to a shortage of a specific type that many of the world's chipmakers can’t produce because they don't have the specialized machinery. That's because the smallest transistors on the most advanced chips really are very different from those on chips that have been around for a few years.

4. Geopolitical risk

Taiwan, which China claims as its own, produces around 20% of the world’s processor chips. A major disruption, such as a conflict, could stop global smartphone production for up to a year, slash personal computer production, and stop the rollout of data centers. Elsewhere, trillion-dollar club companies, like Apple and Microsoft, wouldn't be able to operate without Taiwan-made high-end chips.

Taiwan also makes many of the lower-end processor chips that can be found in many household appliances. If there were to be a major decline in the availability of these low-end models, the implications for world manufacturing would be catastrophic. Recent efforts by governments to reduce their reliance on Taiwan are likely to have limited success because of cost – once subsidies end it'll be more expensive to make chips in other locations.

5. Artificial intelligence

We've seen political leaders in multiple countries trying to explore what levers they can pull over the rapidly developing AI ecosystem. This is amid a growing recognition of the role AI will likely play as a symptom and tool of geopolitical rivalry.

The relatively small number of companies operating in each section of the AI-hardware supply chain makes it easier for politicians to regulate and control. However, the broader AI universe – the rest of the so-called AI stack – will be harder to control because it's much less concentrated than on the hardware side.

Article adapted from a recent episode of our Macro Bytes podcast, “Chip wars: The geopolitics of microchips,” hosted by Paul Diggle and Luke Bartholomew.

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