Negative headlines from Europe continue to weigh on global stocks. This week, the focus is on Spain, which is suffering from a recession and banking crisis. The EU warned that Spain “still had a long way to go to restore investors’ confidence,” and Spanish bond yield spiked above 6.5%. Although stocks have found support around 1,290 on the S&P 500 Index, problems from Europe and weak seasonality would likely cap the market’s upside during the summer. While I believe that we have yet to see the high of the year, it probably won’t happen until the fourth quarter.

Last week, the HSBC flash Purchasing Managers Index (PMI) for China retreated to 48.7 in May from the final April reading of 49.3. It was 48.3 in March. PMI readings below 50 indicate contraction in the manufacturing sector.

While the PMI numbers reflect a slowdown in manufacturing for China, this metric is not as important as it was several years ago. That’s because China is in the transition phase from a primarily export-driven economy into an economy based on domestic consumption. Much like the U.S. has been undergoing since the 1970’s, China’s GDP increasingly is based on goods bought by Chinese consumers.

One metric that explains this quite nicely is the country’s recent retail sales figures. In April, China’s retail sales expanded 14.1% year over year to 1.56 trillion yuan ($247.8 billion), according to the National Bureau of Statistics. After adjusting for inflation, retail sales growth in real terms was 10.7% during the month, with adjusted sales up 1.13% month on month.

The contrast between the sliding PMI numbers and the rising retail sales numbers shows the transition from exporter to domestic consumer in full effect. This new paradigm for China is something we’re taking advantage of in the China Strategy portfolio, as many of our stocks—New Oriental Education (NYSE:EDU), Baidu (NASDAQ:BIDU), Apple (NASDAQ:AAPL) and Changyou.com (NASDAQ:CYOU), among other — are plays on China’s domestic consumer.

The domestic consumption story will continue in the years to come as urbanization rises further and the middle class with its strong appetite for luxury goods and brands keeps growing. Certainly, big-name luxury companies are betting on the domestic wave.

Last week, German luxury car maker BMW AG and its joint-venture partner Brilliance China Automotive Holdings Ltd. announced it would invest €500 million ($628.6 million) to increase production capacity in China, which became BMW’s largest single market in the first quarter of this year. The move certainly suggests that the luxury-car maker remains upbeat about growth potential in China even amid economic concerns in Europe.

Indeed, BMW’s rival car maker Audi was the only luxury car maker in the world that grew during the Global Financial Crisis, with growth driven by China.

Although there is risk of bubbles forming in China’s commercial real estate and construction sectors, unlike in Europe and in other parts of Asia, these projects are largely domestically funded by the Chinese government.

Despite its small income base, the Chinese government still has plenty of firepower in reserve to stimulate its economy thanks to high consumption taxes and steep duties coupled with low debt and a low savings rate. The combination of high savings and low debt ratio in China also allows its economy to absorb a real estate slump. And, as I’ve mentioned before, I expect to see further monetary easing from Beijing in the coming months.

I’ll be flying out to China again tonight to investigate new developments in the Chinese economy and will keep you posted on my findings.