5G - The confluence of technology & geopolitics

18 June 2019

Technology under the radar

Technological advance is typically a function of innovation, invention, capital, opportunity and relevance. Investors understand this well and have long experience of successfully investing in new technologies, changing direction as evidence of its development demands. In this case, however, we also have another, unquantifiable factor that brings significant distortion and inefficiency: geopolitics.

Experience indicates that new technologies are often misunderstood at the early stages, leading investors to underestimate the scope and cost of the new technology and overestimate the speed and ease of its adoption. Historically this has been borne out because almost every new technological advance has ultimately been taken advantage of in ways that were not accurately anticipated at the outset.

5G, or fifth-generation cellular technology, is similarly misunderstood today; its sheer scope and transformational power is wholly underestimated and that has led to the signals revealing threats and opportunities for investors to be blocked by the noise. This is a problem, because 5G will have a long-lasting and long-term indirect impact on investment returns. 5G trials have been held in several countries, notably in the PyeongChang 2018 Winter Olympic Games¹.

The country currently in the lead in 5G development is China, driven by Beijing’s strategic imperative, with the Asia-Pacific region leading the way in 5G adoption. What is perhaps less clear is the extent to which China dominates these subscriber numbers. According to a variety of sources, the majority of the 54 million early adopters next year are in China.

Forecast of 5G smartphone subscriptions by region

Forecast as of November 2018. Source: Ericsson Mobility Report and Statista.

Why 5G matters

Equally importantly, the market is missing the extent to which this technology has become the critical terrain over which the escalating geopolitical struggle between the US and China is playing out.

Source: Gemalto

One of the key advances offered by 5G is extremely low latency, meaning the time it takes to get a response from the server, is extremely low – virtually undetectable to a consumer. To an enterprise or to an industrial user, this is very valuable indeed, as it means that instead of connecting devices to the cloud for storage, it becomes possible to use the cloud connection as an enhancement. Users are able to effectively upgrade the computing power of a device by connecting to the cloud and using much higher-specification machines elsewhere in their organisation to enable much more complex solutions in virtually real time.

Imagine the possible

This functionality is extremely important, as it suddenly enables the real leverage of the capabilities of cloud computing and thus enabling exciting new developments in an enormous range of sectors. In healthcare, this means that remote consultations via 3D holograms and even remote surgery are entirely possible. In transport, it makes the concept of autonomous vehicles much more realistic – especially considering the need to keep vehicles informed real time of other vehicles’ movements on the roads.

Improved latency drives functionality

In these situations, latency and responsiveness are important, but they also require a very high degree of reliability. Today’s 4G mobile networks are very efficient, but work on a ‘best efforts’ basis. So, it is possible for portions of files to be corrupted and require resending. In contrast, 5G has been designed to deliver flawlessly; and that is the same reliability as a wired connection. The offering appears to be quite compelling: with a private 5G network, machines can talk to each other with one millisecond latency and extremely high reliability.

Clearly not everyone will require this degree of latency or reliability, so the cost of this premium service may well prove uneconomical for consumers, although the technology means that the cost per delivery of one megabyte (MB) of data is dramatically reduced and so it is possible to allow revenue/MB to fall quite rapidly and thereby drive up volume of data. For the average consumer, current service based on the Long Term Evolution-Advanced (LTE-A) version of 4G is plenty, meaning that it is industry which may become the early adopter.

The prospect of high-speed analytics taking in vast amounts of video and satellite imagery, data on the ground, and machines very quickly interpreting and providing intelligence back to people in the field to make decisions are clearly high-value factors in healthcare, services and industry.

The other key differentiating factor of 5g architecture will be slicing. This is the key Area fuelling the current Geopolitical focus. 5g Allows the operator (or presumably the Infrastructure owner) to Literally slice a network Into many smaller, virtual Networks.

Slicing the network

The other key differentiating factor of 5G architecture will be slicing. This is the key area fuelling the current geopolitical focus. 5G allows the operator (or presumably the infrastructure owner) to literally slice a network into many smaller, virtual networks. The logic is that this service can be customised and enables different service levels to be provided to different customers. For operators, this is excellent, as it lowers the marginal cost of providing each additional ‘slice’, because it all comes from existing infrastructure.

Where it becomes contentious is that it is theoretically possible for the system to ‘switch off’ certain users at will, or to focus cyber-attacks on subsets of the network without affecting the whole architecture. The perception is that 5G networks will be reliant on a multitude of physical switches and routers that are uniquely vulnerable to hacking by the people who build them. Technically, the hacking threat is probably more acute around IoT. Nevertheless, for this reason, there is an expectation that US companies will be blocked from buying Chinese equipment for communications infrastructure.

So where does this go?

In my opinion, the current US administration’s confrontational approach to China will not just end when the next president assumes office. The concern about China’s ability to penetrate sensitive areas of the country’s infrastructure is deeply embedded and it is likely this will persist for a long time. This means that the US will bar Huawei and other Chinese companies from providing infrastructure or components for the country’s 5G networks. Furthermore, as we have seen recently, the White House has demanded of its allies that they extend a similar ban on Huawei and other Chinese manufacturers from participating in their infrastructure. Australia and New Zealand have already fallen in line and the United Kingdom, Poland and Germany are feeling the pressure. There is logic in the targeting of the members of the ‘Five Eyes’, the intelligence alliance of five anglophone countries (US, Canada, UK, Australia and New Zealand) because of the volume of intelligence they share on a habitual basis. Poland is keen to host a permanent NATO base with US troops and is trying to show willing. Independently, France has severed ties with Huawei following long-established concerns voiced by the country’s security services. The UK may prove to be the weakest link here. Recently, the UK’s intelligence establishment has indicated that it is sanguine about the perceived threat, pointedly contradicting the US position. Besides, once the country leaves the EU, with or without a deal, the UK will need as many friends as possible and trade deals will be at the top of the wish lists. A favourable trade relationship with China would be a significant objective in that scenario.

Finally, while Korea and China have already allocated spectrum, there will be many other 5G spectrum auctions and equipment orders around the world in 2019, raising the tension significantly in the short term.

Beijing will surely retaliate by banning western companies from accessing the Chinese market and redouble its efforts to ensure that all 68 countries which are beneficiaries of Belt and Road Initiative (BRI) investment will accept Huawei and other Chinese manufacturers, while blocking US or European competitors. In fact, there are many countries in South East and Central Asia, and Africa which are happy to use Huawei due to a combination of technological quality and attractive financing terms. The prospect of two competing, but probably deliberately non-interoperable 5G networks is very realistic at this juncture. China will become a powerful arbiter of communications infrastructure across an enormous expanse of the world, fuelling resentment and escalating the nascent technology ‘cold war’.

Conclusion

The scenario I describe is not good for anyone but sadly appears very likely. We are going to have to forget the consensus-based investment of significant sums in 3G and 4G. In the future we will witness near-complete duplication of capital expenditure, resulting in potentially suboptimal technical delivery, potentially with hiccoughs and delays due to a segregated ‘silo’ approach to development. As always in these situations, there will be winners and losers. Clearly Huawei and its peers will be barred from participating in the infrastructure of some of the world’s largest developed economies. Similarly, western companies are likely to be excluded from around 68 countries around the world. Conventional wisdom suggests that customers will lose out, as they will experience limited choice of providers. But it is the operator who will be prejudiced by the lack of choice over network infrastructure providers, so this may have cost implications for capex and cashflow, which in turn may mean the service could become more expensive to the end customer than it might otherwise have been. There is a good example of this already: Australian telecoms firm TGP was planning to enter the Australian market as a fourth network operator and had built out its plans using Huawei equipment – then, once Australia banned the use of Huawei in its 5G network, TPG was forced to suspend its network plans.

The winners are therefore likely to be companies such as Ericsson, Nokia, Qualcomm and other western companies, which can now bid for business in the west with less aggressive price competition from the Chinese, as well as enjoying the certainty of their own market dominance in those same countries. The Chinese companies will probably be winners in their home market as well as in the 68 countries of the BRI.

Logically, TSMC, Samsung Electronics and SK Hynix, which dominate the high-specification end of their sectors would appear to be the clear winners as they will continue to supply chips to both sides. They also enjoy a structural advantage, from being neither Chinese nor western. I would expect them all to come under pressure to pick a side. How much pressure would depend on the prevailing levels of tension between Washington DC and Beijing.For those who think this is far-fetched, we already have a long-established history of the White House applying targeted sanctions to third-country corporates doing business with Iran. Beijing could conceivably point to this as accepted precedent.

The best defence for these companies will be to ensure they remain at the cutting edge of relevant technologies, which could prove enough for a sustainable period. Of these, expect TSMC to be the most sought-after partner by both sides of this conflict, since its dominant position at the cutting edge of research and development in 5G and smart IoT applications is unrivalled in the sector. Perversely, the company’s location in Taiwan and its significant footprint in mainland China work simultaneously as a Kevlar jacket and a magnet for potential belligerence from Beijing. However, I would not expect this to escalate unless the extreme scenario of an annexation of Taiwan were to be on the cards.

Finally, for the telecommunications operators, 5G represents a new source of revenues. In a world where the operators will have to keep investing significant sums on spectrum auctions as well as in capital expenditure, industry digitalisation represents the promise of much-needed relief. Whether this new revenue source is large enough to compensate for the higher capex, remains to be seen. But even here, geopolitics will be an important driver, as each national government’s imperative may determine the speed, extent and urgency of 5G development, indirectly setting ceilings on returns for shareholders for some time (the most exposed here are clearly the Chinese operators).

In the last 70 years, investors have had the relative luxury of considering only financial and technical information in their judgement of the fundamentals to inform their investment decisions. We are now in an era with echoes from 100 years ago, when commerce was distorted by the relatively unquantifiable driver that is geopolitics – and this is only the beginning.

¹5G was on display via a drone light show, a connected car in Seoul, and interactive multi-angle HD video streaming.

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