It’s a peculiar sort of problem when your economy grows at 8.1% in the first quarter and yet talk abounds of a “hard landing.”  American and Europeans haven’t seen that kind of growth in decades—and they could desperately use it today.  Yet such is life is China; after years of growing at a blistering pace, growth of “only” 8.1% represents a slowdown.

The 8% mark is considered by many to be the minimum growth rate that China needs to maintain high employment and to keep living standards rising.  And by the government’s own calculations, Chinese growth will likely slip below that level for the full year 2012.  Citing weakness in China’s European export markets and lower construction spending, the Chinese government lowered their full-year target to 7.5%.

The Chinese government doesn’t take its own GDP numbers seriously (they know the numbers are baked), and neither should we. But other statistics are even more sobering.

Consider the tepid growth in imports.  China’s imports grew by a pitiful 0.3% in April, compared to an average growth rate of 25% throughout 2011.  It is no shock that this has coincided with a general sell-off in commodities prices.  More on that shortly.

Let’s take a look at what China’s leaders themselves find important.  Li Keqiang, China’s heir apparent as premier, let on that he watches three indicators to gauge the direction of the Chinese economy (see his comments): electricity consumption, rail cargo, and bank lending.  None tells a particularly optimistic story.

Electricity consumption grew by just 0.7% last month vs. 7.2% the month before.  Growth in rail cargo volume has been cut in half.  And bank lending?  With the government actively trying to deflate a housing and construction bubble, it has slowed dramatically.

Now that I’ve bombarded you with scare statistics, how should we react as investors?

First, step back and try to keep perspective.  Yes, there is a steady stream of bad news coming out of China that signals slow growth ahead.   But “slow growth” is clearly a relative term when your economy is growing at a 7-8% clip.

China’s leadership are not fools, and they realize that the model that has served them so well in recent decades—manufacturing cheaply and exporting to the West—is broken.  It’s hard to find success as an export-driven economy when the buyers of your products are grappling with a crippling debt crisis.

Realizing this, China’s leadership indicated earlier this year that “the key to solving the problems of imbalanced, uncoordinated, unsustainable development [in China] is to accelerate the transformation of the pattern of economic development. This is both a long-term task and our most pressing task at present.”

In other words, it is the stated objective of the Chinese government to deemphasize investment and instead boost domestic consumption.

Investors wanting to profit from the reorientation of China can follow two trends:

  1. Avoid commodities and the firms that produce them or even look for opportunities to go short.  China has been the overwhelming force behind the commodities bull market of the past decade, and without aggressive Chinese buying there is no bull market.
  2. Buy the companies that stand to profit from a Chinese consumer shopping spree.  My preferred “fishing pond” is the luxury goods sector, defined here as everything from flashy handbags to performance automobiles.

Consider what the Economist has to say about China’s demand for luxury:

More than half of this year’s growth in luxury goods will come from China, where sales are set to soar by 24% in 2012. The country is already the largest market for jewellery after America, and for gold after India, and is gaining fast on both leaders. Prada and Gucci owe a third of their global sales to the rich in China. CTF saw same-store sales on the mainland shoot up by 45% from April to September last year.  See “Riding the Gilded Tiger

According to the Financial Times, emerging markets account for 40% of all luxury sales (up from 27% as recently as 2007), and this does not include wealthy emerging market tourists who buy in the shops of New York or London.  Again, according to the Financial Times, as much as half of the luxury sales in Europe are to emerging-market tourists, many of whom hail from China.

This week Richemont, owner of the Cartier brand (among many others) and the world’s second largest luxury retailer by sales, announced that sales and profits rose 29% and 43%, respectively, largely on strong demand from China.  Perhaps surprisingly, demand in Europe was robust, with sales up 20%.  Crisis or not, it would appear that well-heeled consumers are spending freely on life’s frivolities.

The crisis in Europe has make the luxury goods sector all the more interesting.  Most of the biggest names in high-end luxury goods are European firms, and with the Eurozone mired in crisis we’re getting buying opportunities we might not see again for a long time.

One of my favorites is French luxury conglomerate LVMH ($LVMUY), the maker of Louis Vuitton handbags, Dom Perignon champagne, and many other delightful goodies.  Mercedes-Benz manufacturer Daimler AG ($DDAIF) is also an excellent play on Chinese growth.  China is the biggest market for the Mercedes S-class and the biggest engine of the company’s growth.

Investors wanting to stay closer to home could consider Beam, Inc. ($BEAM), the distiller or Jim Beam Maker’s Mark bourbon whiskies and Skinnygirl cocktails among others.    Beam is a smaller rival to international spirits juggernaut Diageo ($DEO), and its brands lack some of Diageo’s cachet. Still, Beam is attractive as a recent spinoff from Fortune Brands, and it stands to grow at a significantly faster pace in the years ahead.  I consider both excellent holdings for the next 12-24 months.

Disclosures: LVMUY, DDAIF, DEO and BEAM are held by Sizemore Capital clients.

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