Stuart Wilson, head of portfolio management at Canaccord Genuity Wealth Management, explains why a global shortage of microchips is causing problems for the car industry. He writes...

Supply chain challenges are just one reason why the cost of living is rising so quickly.

But they are also causing problems for manufacturers, who are struggling to acquire vital components.

Recent figures released for the UK car industry show a sharp fall in activity, with new car sales in June down 24% on last year. This is partly because consumers are reining in their spending, but also because there is a shortage of one vital component that goes into every modern car: microchips.

The invention of the semiconductor chip is up there with humanity’s greatest achievements.

These tiny items, made of silicone, cobalt, and copper, sit inside almost every modern electronic device, including your car, phone and computer. But the problem is we don’t have enough of them.

The percentage of a car that is comprised of electronics has been steadily increasing, from 18% of the total cost of a car in 2000 to about 40% today.

This seems obvious when you think of safety features like adaptive cruise control, or automated stopping if there’s a pedestrian in front of you.

When Covid-19 hit, many car manufacturers assumed demand was going to fall sharply. So, they cut back orders. Meanwhile, demand rocketed for consumer electronics such as laptops, due to lockdowns and working from home.

When it emerged that car sales weren’t going to be as dramatically impacted by Covid-19 as initially thought, manufacturers went back to the suppliers, and discovered the chips were not available. Unfortunately, it takes dozens of weeks to make a new semiconductor, and you can’t turn production on quickly. The biggest customers for chips are mobile phone makers, who are prioritised over automotive companies. Car chips can also be harder to make. Their temperature range, operating lifetime, and failure rates must be better. While your laptop’s light sensor can fail without endangering lives, your car’s adaptive cruise control can’t.

The world has a fixed semiconductor supply. Semiconductor factories are incredibly expensive and relatively low margin to build, and might be obsolete in five years. So they depreciate quickly, contributing to chip supply problems.

In turn, the investment industry has rewarded companies that design chips, but don’t actually make them, as they provide higher profit margins.

Taiwan, one of the world’s biggest manufacturers of semiconductors also recently went through a drought, exacerbating the shortage because the process of chip production is highly water-intensive.

If there were no politics, China would be the obvious choice for manufacturing semiconductors to fill the gap.

However, companies in the semiconductor tool chain in the United States have to apply for licences to sell to Chinese companies. The US is worried that China will buy semiconductor manufacturing equipment, reverse engineer it, and then make their own semiconductors.

What are the implications for investors?

A technology supply chain affects plenty of businesses outside the technology sector. This presents opportunities to invest in companies that can innovate to make this process more efficient or resilient. As ever, whenever there is a problem, creative companies will find a solution.