China's Economic Divergence: Rotate to Consumer Resilience, Avoid Tariff-Exposed Manufacturing

The May 2025 economic data from China reveals a stark divergence: retail sales surged 6.4% year-on-year—the fastest pace since late 2023—while industrial output growth slowed to 5.8%, marking a six-month low. This split underscores a critical opportunity for investors to pivot toward domestic consumption sectors while cautioning against overexposure to manufacturing amid persistent trade headwinds.

Retail's Resurgence: A Catalyst for Consumer Discretionary Plays

The retail boom, fueled by extended holidays, government consumption vouchers, and early "618" promotions, has breathed life into sectors like e-commerce, luxury goods, and leisure travel. Alibaba and JD.com saw traffic spike as early as April, while luxury brands like LVMH and Kering reported robust sales in tier-1 cities.

This outperformance is supported by policy tailwinds: Beijing's "Cash for Clunkers" trade-in program and regional subsidies in cities like Shanghai have directly boosted car and appliance sales. Meanwhile, urban unemployment dropping to 5.0% in May signals labor market resilience, further underpinning consumer confidence.

Manufacturing's Malaise: Trade Tensions and Overcapacity Weigh Heavily

Industrial output's deceleration reflects structural challenges. The 34.5% plunge in U.S. exports—a direct hit from 55% tariffs—has eroded demand for sectors like machinery, auto parts, and electronics. Even as shipments to Southeast Asia and the EU rose, they couldn't fully offset the U.S. decline.

Overcapacity in manufacturing remains a drag. Capital Economics notes that deflation in producer prices (-3.3% in May) and weak domestic demand highlight excess supply. Investors should avoid industrial stocks with heavy reliance on external markets, such as machinery exporters or commodity-dependent firms.

Sector Rotation: Favor Domestic Demand, Hedge Export Risks

Buy:
- Consumer Discretionary: Retail, e-commerce, and leisure stocks (e.g., Meituan, Ctrip) benefit from policy support and urbanization-driven consumption.
- Healthcare & Services: Rising disposable income and aging demographics favor hospitals and wellness companies.

Avoid:
- Manufacturing: Sectors like machinery and auto parts remain exposed to trade risks and overcapacity.

Valuations and Policy Support

Consumer discretionary stocks trade at a 20-30% discount to their pre-pandemic valuations, despite stronger earnings visibility. Meanwhile, industrial sectors face valuation headwinds due to slowing margins.

Beijing's cautious monetary easing—PBOC rate cuts in May—suggests policymakers prioritize stability over aggressive stimulus. Look for targeted measures like tax breaks for small businesses or rural consumption incentives to further buoy domestic demand.

The Export Rebound: A Potential Tailwind, but Uncertain Timeline

Exports could stabilize if U.S.-China trade tensions ease. A prolonged tariff truce or phased tariff reductions could unlock a rebound in 2026. Investors might consider selective exposure to exporters with diversified markets (e.g., automakers with strong ASEAN ties) or sectors benefiting from China's "Going Out" infrastructure projects.

Risks to Watch

• Property Market Collapse: A further 10.7% drop in property investment this year could spill over into consumer sentiment and local government revenues.
• Trade Volatility: U.S. election dynamics in 2026 may reignite tariff disputes.

Conclusion: Rotate Now, but Stay Nimble

The May data confirms a clear divide in China's economy. Investors should overweight consumer discretionary equities and underweight manufacturing until trade risks abate. Monitor the U.S.-China tariff talks closely: a resolution could trigger a rotation back into export-driven stocks, but for now, domestic demand is the safer bet.

Investment Takeaway:
- Overweight: Consumer Discretionary ETFs (e.g., FXI's consumer basket), leisure stocks, and e-commerce leaders.
- Underweight: Industrial stocks tied to U.S. exports or cyclical manufacturing.
- Hedge: Use put options on export-heavy sectors to protect against further tariff escalations.

The path to China's 5% GDP growth lies in its consumers—and investors ignoring this split risk missing the next phase of market leadership.