DeepSeek and Chip makers: Riding the silicon rollercoaster

The semiconductor industry, long accustomed to its cyclical volatility and relentless pace of innovation, now finds itself at a precipice where familiar challenges intertwine with an emerging, formidable force. The latest headlines surrounding DeepSeek—a company whose cost-effective AI model has sent ripples through the market—underscore the growing pressure on this sector, already grappling with its capital intensity and the inexorable march of technological obsolescence. Yet, looming larger than any single development is the rise of China, whose ability to optimize performance with limited access to high-end technology threatens to redefine the competitive landscape entirely.

China, long dismissed as a technological laggard, has emerged as a force to be reckoned with. Its ability to optimize performance with limited access to high-end technology is not just impressive—it’s revolutionary. This achievement, coupled with the country’s state-backed investments and proven strategy of flooding markets with lower-cost alternatives, poses an existential threat to established semiconductor players. China has already demonstrated its disruptive prowess in industries as varied as solar panels and electric vehicles. Now, it turns its gaze to semiconductors, a sector whose vulnerabilities—cyclical downturns, overcapacity risks, and staggering capital requirements—make it ripe for disruption.

Since October 2022 America has blocked the sale of high-performance processors to China. Some Chinese firms are rumoured to be turning to the black market to get their hands on these coveted chips. But the majority have shifted their focus to making the most of limited resources. Their results are giving Western firms food for thought. Among the innovators is DeepSeek, a Chinese startup based in Hangzhou. Its latest model, DeepSeek-v2.5, launched in early September, holds its own against leading open-source models on coding challenges as well as tasks in both English and Chinese. These gains are not down to size: DeepSeek is said to have just over 10,000 of Nvidia’s older GPUs—a big number for a Chinese firm, but small by the standards of its American competitors. (The Economist, Sept 2024)

Wall Street’s misplaced optimism

The AI infrastructure market’s meteoric rise is a testament to the industry’s potential—and its vulnerability. Nvidia’s ascent to a $3 trillion market capitalization by 2025 epitomizes this explosive growth. The total value of AI companies surging from $283 billion in 2014 to $8.9 trillion by 2024 is not just growth; it’s a seismic shift in the technological landscape.

Yet, this very success may be the industry’s undoing. DeepSeek’s reported ability to develop a competitive AI model for just $6 million—a figure that remains unverified yet widely circulated—has raised uncomfortable questions about the necessity of massive capital expenditures in AI hardware. Western firms have spent billions chasing cutting-edge capabilities; yet DeepSeek’s success suggests that efficiency and ingenuity may trump sheer financial muscle. The market has taken notice: Nvidia’s shares have wavered under this new scrutiny, while other AI-related stocks have also faced sharp declines. Investors appear to be reassessing their faith in the notion that only astronomical spending can secure AI leadership.

The semiconductor industry’s capital intensity is not a strength; it’s a vulnerability

At its core, the semiconductor industry’s challenges are rooted in its capital intensity—a characteristic that magnifies its exposure to cyclical risks. Building a state-of-the-art fabrication facility costs upwards of $10 billion, and the equipment within these fabs often becomes obsolete in as little as five years. Leading-edge foundries like TSMC operate with capital intensity ratios exceeding 37%, underscoring the immense financial burden required merely to stay competitive. This heavy investment frequently leads to overcapacity during downturns—a recurring feature of the industry’s cycles—exacerbated by inventory buildups and weakening demand across consumer electronics and industrial applications. The sector remains acutely vulnerable to economic shocks.

Conviction that semiconductors are in a secular growth phase is not optimism; it’s delusion

Yet Wall Street clings stubbornly to its belief that semiconductors are entering a secular growth phase driven by AI demand. This optimism overlooks two critical realities: first, that semiconductors remain deeply cyclical, with boom-and-bust patterns tied inexorably to inventory dynamics and macroeconomic conditions; and second, that China is rapidly closing the technological gap—not merely through brute-force investment but through strategic innovation in areas like advanced packaging and silicon carbide (SiC) semiconductors.

If China can leapfrog in AI applications—as it has demonstrated with cost-efficient training models like those of DeepSeek—there is little reason to doubt its ability to achieve similar breakthroughs in chip manufacturing. The country’s state-backed investments enable it not only to scale production but also to undercut global competitors on price—a strategy it has deployed with devastating effectiveness in other industries. As China doubles down on mature-node chips and enhances its capabilities in memory and logic semiconductors, global margins could face severe compression.

For companies reliant on high-margin products or legacy chips, this could spell significant trouble. Even cutting-edge players like Nvidia may find themselves under pressure as Chinese firms develop competitive alternatives tailored for domestic markets. The implications are profound: a sector once defined by Western dominance may soon find itself reshaped by Chinese ingenuity and scale.

This is not just another cycle, in ways many should fear to imagine

The semiconductor industry is not merely navigating uncharted waters; it is bracing for a storm. A cyclical downturn coinciding with China’s strategic rise creates an environment fraught with risk for both investors and manufacturers alike. The capital-intensive nature of chipmaking amplifies these vulnerabilities further still, while technological obsolescence demands relentless innovation just to maintain relevance.

China’s ability to optimize performance with inferior tools is not merely a testament to resilience—it is a declaration of intent. As Beijing continues to innovate despite sanctions and restrictions, the global semiconductor landscape stands on the brink of dramatic transformation. For established players lulled into complacency by Wall Street’s secular growth narrative, this time will indeed be different—but not in ways they might have hoped or imagined. It will be different because it must be: survival demands nothing less than adaptation on an unprecedented scale.