The volatility that has attacked financial markets since the New Year has led to countless calls from concerned clients. Thanks to a seemingly limitless amount of headlines and commentary from the "experts" on TV, fear and panic has led many retirees to believe that China is doomed and will drag down the U.S. with it.
Three catalysts have fueled the volatility lately:
A slowing economy
Stock-market mayhem
Currency manipulation by their government
Let's assess the state of China's economy and equity market to determine any potential long-term impact on your retirement.
A slowing economy
China's economy is absolutely slowing down, but that fact is not concerning on its own. When countries and companies grow past a certain point, their growth rates naturally fall. For example, Apple is the world's largest publicly traded company, but they can no longer double in size each year anymore, unless everyone bought six additional iPhones this year.
The question that should be asked is whether China is still contributing to the global economy, and the answer is an unequivocal "yes." China was about half the size a decade ago, but growing twice as fast today, which actually comes out to around the same amount.
China may be slowing, but what's more noteworthy is that they are also transitioning. Much of their growth over the last several decades came from manufacturing, and the government is committed to converting the economy to a more consumer-driven one, much like the U.S. economy.
These transitions are bumpy and take time because they require major structural and cultural shifts, but they are doing what is needed to strengthen their economic future.
The world's largest casino
China's stock market is vastly different from ours due to (1) the composition of investors and (2) the connection to the underlying economy.
The U.S. stock market is dominated by institutional investors, such as banks, insurance companies, and endowments, all of which are professional investors with long time horizons.
On the other hand, China's stock market is nearly all "retail" money. These are everyday consumers with little to no training in the mechanics of equity markets. Hence, periods of volatility are amplified because most participants there are gambling instead of investing.
The connection to the economy is also quite different than here. Institutions dominate our stock market, and they invest based on predictions of the impact of economic cycles on asset prices. Hence, the equity market here tends to anticipate and move with the economy over longer periods of time.
China's stock market has soared and crashed in the face of economic data that has experienced far less volatility over the past two years. Hence, what goes on in their stock market cannot possibly be used as a barometer for economic health because the two act independent of each other.
Simply put, China's equity market is the world's largest casino and bears no semblance to the underlying economy.
Currency manipulation
Investors fear that China's central bank, the People's Bank of China (PBOC), is intentionally weakening the country's currency to jump start their economy by making exports more attractive. Currency manipulation often fuels paranoia.
However, the PBOC has manipulated China's currency for decades, and they are implementing positive changes alongside the weakening that will allow their currency to be more freely traded.
China is not going to just give up full control overnight, so they are attempting to do so in an orderly manner. The real problem is that they have not done a great job since they announced their intentions back in August.
This road will also be bumpy, but the ends will justify the means when they arrive because markets, not communist regimes, should determine the value of a currency.
Does China even matter?
Any sound analysis must consider the bear argument on China by assuming that it really is a house of cards. In this scenario, it's important to assess the impact on (1) the U.S. economy and (2) our stock market.
Our economy is rather self-contained, and we rely very little on China as a customer. Currently, China accounts for less than 7% of our exports, and exports to China constitute less than 1% of our annual GDP. Combine Canada and Mexico together, and the total of what we export to our neighbors is 4.5 times more than what is sent to China.
The effect on our stock market is another story and would likely evolve over time. In the short-term, volatility would likely spike due to the fear and panic of witnessing the world's second largest economy crumble.
However, over the long run, our stock market is driven by fundamentals. If our economy were to feel little impact from a fallen China, our stock market would eventually reflect this outcome.
Implications for retirees
Rewind the clock back to August, and the causes of volatility look identical to the ones today (China, commodities, geopolitical scares, etc.). These issues still remain at large, and until they are resolved, retirees' investment portfolios will continue to be exposed to periodic volatility.
The good news is that repeated volatility tends to wane over time, and this recent bout has been no different. It's a lot like going to the gym after an extended period of rest. That first time back is going to be painful because it is an unexpected shock to the system, but the second session should not hurt as much as the first because the body is becoming conditioned to the pain.
The same applies to volatility. Investors become conditioned to repeated headlines over time, and they learn to ignore the pain. For example, Greece wreaked havoc last summer, but it barely makes the news anymore, despite a situation that has arguably deteriorated since then. It's become old news now because we better understand that Greece can't derail our economy.
The bottom line is that China's stock market will not impact your retirement unless you let it. Financial markets recovered from August's volatility spike in a matter of weeks, and although it's impossible to say whether history will repeat itself, there is little evidence to support the notion that a slowdown in China can drag the U.S. economy down.
