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Why Jim O’Neill is right about China – and how you can profit

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While the world was fretting last week about the poor data from the People's Republic of China , observers like Goldman Sachs emerging market guru Jim O'Neill were heartened by the potential confirmation of a necessary change in the Chinese economy's ( FXI , quote ) composition.

[caption align="alignright" caption="Jim O'Neill at a special world debate featuring Economic Historian Niall Ferguson, French Finance Minister Christine Lagarde, International Monetary Fund's Managing Director Dominique Strauss-Kahn and Chairmwoman of Sabanci Holding Guler Sabanci"] [/caption]

For traders and those used to evaluating Chinese data based on traditional metrics, the numbers released last week were dismal with exports, imports, and industrial production all slumping. As many are eager to point out, weaker trade is symptomatic of a global economic environment struggling with recessionary pressures in Europe stemming from their currency crisis.

Traders with a short-term time horizon are right to be skeptical of the Chinese economy in the near future as trade remains the driving force behind the world's second largest economy. As firms like UBS lower their FY 2012 growth forecasts for China, the notion that the country is facing a hard-landing continues to grow.

However, this sort of reductionist narrative neglects the fundamental transformation taking place within the Chinese economy. As the neo-Mercantilist Guangdong model of growth fueled by cheap exports and cheaper labor becomes less and less feasible , China has to move away from an economy fueled by trade surpluses to one driven by consumption.

The Guangdong model is becoming less viable for China's coastal provinces as the result of rising wages and, until recently, a strengthening renminbi. As a result, the goods manufactured in provinces like Guangdong, Fujian, and Zhejiang become more expensive, and thus less attractive to importers abroad. This has caused some low-end companies to look elsewhere for their production, both to inland Chinese provinces like Sichuan and Chongqing municipality, and to countries with lower wage structures like Vietnam.

On the other hand, more and more companies who produce more advanced goods in China are considering moving production back home to their respective Western countries, now that China's cost advantage has been significantly reduced. While it may still be more expensive to pay for American or European labor, for some firms the increased reliability, reduced capacity for supply-chain disruption, elimination of concerns over intellectual property, and enhancement of brands by producing at home outweigh the extra outlays for labor.

As a result, some of China's competitive advantages in export manufacturing are waning. While exports will continue to be an integral part of the Chinese economy, especially given the size of China's unparalleled semi-skilled workforce, the country is trying to diversify its economy and move towards increased consumption, which is imperative for the economy's viability going forward. As Jim O'Neill notes, last week's data is indicative that this transition may be underway and that other macroeconomic factors may allow China to navigate in the medium-term better than some pundits expect.

While industrial production data predictably fell well short of expectations on the back of woes from China's largest trading partner Europe - retail sales fared just fine. O'Neill says that [pdf] although "retail sales report disappointed also at 'just' 14.1%, this is not too shabby. Retail sales rising strongly relative to industrial production is what China needs and what the world needs of China."

Furthermore, China reported much lower than expected inflation numbers, coming in at a relatively low 3.4%. Considering that rivals India and Vietnam are dealing with inflation around 7% and 11%, respectively, China's low inflation affords the People's Bank much more policy flexibility to stimulate the Chinese economy.

As O'Neil points out, "financial conditions have been tightened a lot in the past two years. And unlike so many Western countries, they can be relaxed significantly." As a result, "more easing is coming."

The takeaway for investors is that entrenched companies that cater to middle-class Chinese consumers are poised to take advantage of this trend towards consumption. This includes such American companies with large Chinese operations as YUM! Brands ( YUM , quote ), Starbucks ( SBUX , quote ), Coach ( COH , quote ), Las Vegas Sands ( LVS , quote ), and Apple ( AAPL , quote ). As well, Chinese companies locked into the consumer such as China Mobile ( CHL , quote ) and Tencent Holdings ( TCEHY , quote ) will likely outperform. E-commerce firm Dangdang ( DANG , quote ) also appears to be well-positioned, but out of principle, I can't recommend a Chinese small-cap.

Conversely, firms that are dependent on the export boom for their bottom line could underperform here. Unfortunately, most of these firms, like Foxconn, don't trade in the United States. The trend of more expensive labor in the coastal regions has not been lost on Foxconn; the firm is already experimenting with automation and moving factories inland in order to keep their model viable.

As well, American firms who employ Chinese labor are unlikely to be dramatically affected; when labor becomes too expensive, companies just move their factories elsewhere. For those looking to take advantage of this trend from the short side, although something of a second-derivative trade, the Chinese financials ( CHIX , quote ) already look weak because of their poor loan portfolios . Given that many of these banks have significant loan exposure to export-producing Chinese companies, a drop in exports could see these loans, and in turn, the banks that provided them underperform.

Investors with a long-term time horizon shouldn't count China out just because of weak trade and industrial production data. By embracing this sea change in the Chinese economy and going long companies in tune with Chinese consumers, investors should continue to see gains from companies with China exposure, especially those that dovetail nicely with the themes outlined by Jim O'Neil.

Disclosure: Author is net long LVS and AAPL; Family is net long YUM, SBUX, LVS, and AAPL

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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