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Why China Should Be Part of a Long-Term Investment Portfolio

Investing in China is a controversial topic, with China bulls and bears almost as far apart as supporters of Hillary Clinton and Donald Trump.

Bulls and bears talk "at" each other, often with red faces and raised voices. Although the debate about China may be as polarized as the presidential debate, it is possible to present an unbiased view that acknowledges both sides of the argument.

Despite the significant challenges on the horizon for China, long-term investment portfolios should include investments in Chinese stocks.

[See: 13 Stocks to Buy to Bet on China.]

Addressing the risks. Many commentators cite the slowdown of Chinese GDP growth as a reason to avoid China. GDP growth according to official statistics, which was 11.4 percent in 2005 and in double-digit levels as recently as 2010, fell to 6.9 percent in 2015. Private estimates are for Chinese GDP to fall further in 2016 than official statistics would indicate, with consultancy Capital Economics projecting 5 percent growth. An important consideration, however, is the size of China's economy in 2016 relative to its size in 2005. China's economy is more than five times larger today, so 5 percent growth on a much larger economy base is still quite robust. In a recent speech, Matthews Asia's Andy Rothman commented about the need to "get away from the obsession with China's GDP growth rate."

China's corporate sector binged on debt in recent years, in large part because of massive infrastructure spending initiated to stabilize the economy in response to the global financial crisis. Private debt in China represents more than 200 percent of GDP, far higher than the peak of U.S. private debt before the GFC and approaching the high reached by Japan in 1990. The explosion of debt creates fear that China will face a banking crisis and hard landing, repeating post-bubble cycles experienced in the U.S., Europe and Japan.

The debt picture may be more nuanced than alarmist headlines would indicate. The central government is the largest shareholder in most of China's major banks, and a significant portion of the private debt was extended on behalf of the government as a form of fiscal stimulus. In the words of Rothman, "the potential bad debts are corporate, not household debts, and were made at the direction of the state, by state-controlled banks to state-owned enterprises." Although China's corporate debt is uncomfortably high, household debt is low and government debt is only 44 percent of GDP.

China's overall debt, including corporate, household and government debt, is comparable to that of the U.S. and U.K. and considerably lower than that of Japan, France and Canada. That may not be unequivocally great news -- as 255 percent debt-GDP ratio is still uncomfortably high -- but it's important for context-setting. Perhaps most importantly, very little of China's debt is owed to external parties, so China (at least for the time being) has considerable latitude as to the approach and timing of structural change to reduce its private debt.

China's leaders face a difficult balancing act: maintaining enough growth to preserve social stability while addressing the need to restructure debt-laden, money-losing state-owned enterprises. The slow pace of reform among state-owned steel, coal and electricity companies that dominate China's rust belt is a concern, but the stereotype of China as an export-focused, state-dominated economy isn't true anymore. Exports are a small part of China's economic output, and the private sector is the dominant economic engine for the country.

[See: 11 Stocks That Donald Trump Loves.]

Embracing the opportunities. A "slower-growth" China accounts for about one-third of global growth, a higher proportion than was the case in 2010 when China's GDP growth was 10 percent. Private sector employment is more than 80 percent of total employment in China, and outside of the manufacturing sector there are more jobs than job seekers. China may be the best consumer story in the world, and the rise of the consumer class in China is very real. Real household income rose more than 130 percent over the past decade, a noteworthy advance compared to nearly non-existent income growth for developed market households.

China's consumers are in good shape, with high savings, low debt and rising household income. Retail sales in China gained 10.6 percent year over year in August, continuing a strong multi-year trend. The middle class, about 8 percent of the population today, is expected to triple to 300 million people by 2020. An aging population also provides opportunities, as 16 percent of the population (220 million) are age 60 or older today. Some of the most exciting opportunities are with the consumer-oriented companies that benefit from rising incomes, health care companies that support a more affluent (and aging) society and industrial companies helping to improve manufacturing consistency. Many of these companies didn't exist 10 years ago.

Addressing China's structural problems, including high corporate debt and sluggish state-owned enterprises, won't be an easy process, but is likely to result in slower growth, pressure for currency adjustments and continued volatility rather than a crisis or hard landing. Despite the risks and volatile ride, China is likely to be an attractive investment destination for the patient investor.

[See: 20 Awesome Dividend Stocks for Guaranteed Income.]

Investments in securities are not insured, protected or guaranteed and may result in loss of income and/or principal. This communication may include opinions and forward-looking statements. All statements other than statements of historical fact are opinions and/or forward-looking statements (including words such as believe, estimate, anticipate, may, will, should and expect). Although TFC Financial Management believes that the beliefs and expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such beliefs and expectations will prove to be correct.

Dan Kern is chief investment strategist for TFC Financial Management, a wholly independent, fee-only, financial advisory firm based in Boston. TFC's revenues are derived solely from the fees it charges for the services it provides. Prior to joining TFC Financial Management, Dan was president and CIO of Advisor Partners. He is also a former managing director and portfolio manager for Charles Schwab Investment Management, managing asset allocation funds and serving as CFO of the Laudus Funds, and was managing director and principal for Montgomery Asset Management. Dan graduated from Brandeis University and earned his MBA in finance from the University of California, Berkeley. He is a CFA charterholder and a former president of the CFA Society of San Francisco, and sits on the board of trustees for the Green Century Funds.

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