Vanguard : China: What does Vanguard think?

If not for the weather, it might be August. Chinese stocks fell sharply in the first trading days of 2016, an echo of their summer 2015 tumble. As in August, shakiness in Shanghai has rattled stock markets around the globe. Developed and emerging markets in Europe, North America, and Asia have opened the New Year with a thud.

What does Vanguard think? The volatility in China is hardly surprising. It's consistent with the generally higher volatility of emerging markets and with the specific financial and economic transformations under way in China. And despite the bold headlines, weakness in China and its global aftershocks have limited relevance to most Vanguard investors.

A giant pivots

As we noted in Vanguard's economic and investment outlook for 2016, the high-growth 'Goldilocks'era enjoyed by many emerging markets through the past two decades is over. From 1990 through 2007, China expanded at an astonishing average annual rate of 10%. In less than two decades, in other words, the value of Chinese economic output more than quintupled.

The rapid growth reflected heavy investment in manufacturing and real estate, which ultimately led to overinvestment and overcapacity. As China rebalances its growth drivers from investment and exports toward domestic consumption and services, we expect economic growth to decelerate to a sustainable rate in the mid-single digits.

This long-term transition will prompt occasionally pronounced market reaction. On January 4, Chinese stock prices lost about 7% of their value, which resulted in 'circuit breaker'trading suspensions for the day. A catalyst was a decline in the government's monthly index of manufacturing activity. The decline was consistent with broader economic expectations, but nevertheless rattled jumpy investors.

Another source of nervousness has been pressure on the Chinese currency, which has declined relative to the U.S. dollar (while remaining steadier relative to a more meaningful trade-weighted basket of currencies). Does the decline reflect investor expectations of greater weakness in the Chinese economy? Confusion about a new approach to exchange-rate management by the central bank? Seasonal factors? The questions and speculation contribute to an air of unease.

Implications for investors

What does the recent tumult mean for Vanguard investors? Very little. Most Vanguard investors have limited exposure to Chinese stocks. As of November 30, 2015, Vanguard Total World Stock Market Index Fund, which includes all global stock markets in proportion to their market values,* held just 2.2% of its assets in Chinese stocks. Hong Kong stocks made up another 1.2%.

For an investor with a diversified mix of stocks and bonds, the exposure is more modest still. At the end of November, Vanguard Target Retirement 2020 Fund, which has about 60% of its assets in stocks and 40% in bonds, held 1.1% of its portfolio in Chinese stocks.

What if trouble in China sparks new turmoil in global stock markets? Stock market volatility is inevitable, but manageable. Stocks boast the potential for higher long-term returns than bonds and cash precisely because they're riskier. The New Year is off to a rough start, but for the five years ended December 31, 2015, global stock markets produced an average annual return of 6.4%, outperforming bonds and cash.

*The fund seeks to track the performance of the FTSE Global All Cap Index, a float-adjusted, market-capitalization-weighted index designed to measure the market performance of large-, mid-, and small-capitalization stocks of companies located around the world.