With the unemployment rate creeping higher and many households focused on paying off debt and increasing savings, the financial media has spilled a lot of ink speculating about the death (or at least the retirement) of the US consumer and its implications for the nation’s economy. As manager of Fidelity Select Consumer Discretionary (FSCPX), John Harris has his finger on the pulse of spenders big and small. We sat down with Harris to discuss where we are in the discretionary cycle and where investors should look if they want to make a cyclical bet on recovery.

The financial media continues to paint a dour picture for consumer spending. What’s your outlook for the economy and the consumer-discretionary sector?

Conditions are less bad compared to a year ago, when Lehman Brothers failed and negativity abounded. People are starting to feel a bit better; consumer confidence numbers are up, and home prices and sales turnover are starting to show signs of improvement.

The deflation that we’ve seen in commodity prices, food prices and energy helps, especially in the case of the most budget-constrained consumers. In other words, if you’re employed, you’re enjoying real average hourly wage growth as a function of declining inflation.

At the same time, unemployment continues to head higher, and discussions of a jobless recovery carry a negative undertone. And although most companies’ revenues continued to decline, many have managed cost structures and inventory positions well enough to generate earnings growth.

Many analysts expect revenue growth to return in the fourth quarter, thanks to a relatively forgiving comparison to the fourth quarter of last year.

I’m not looking for the classic V-shaped recovery; a number of meaningful headwinds remain in play–for example, the wealth destruction that occurred in the wake of the housing bubble. And although equities prices are up substantially since the March lows, they still aren’t what they were a year ago. Consumers have a massive hole in their balance sheets that needs to be fixed; that plug will largely come in the form of increased savings.

Consumers have already modified their savings behavior. Over the past few quarters, the savings rate went from near zero to mid-single digits. That number is still down from 15 years ago, when the savings rate hovered around the low double digits. Households are in the process of deleveraging and reining in spending. The level of consumer debt outstanding actually declined year over year for the first time since 1992. Meanwhile, the financial obligations ratio has reverted to levels last seen in 2001 or 2002.

Asset price inflation could help, but we haven’t seen that kick in yet.

Consumers are modifying their spending to cope with the tougher environment; once that cycles out, growth should return to normal. The new normal won’t replicate the economic growth the nation enjoyed between 2003 and 2006, when consumers juiced spending by tapping home equity like it was a piggy bank, but I expect a little bit of growth this year and low single-digit growth in 2010.

Multinationals have been the best performers in this space; will international demand be a key growth driver going forward?

Multinational companies are benefitting from better earnings growth in some emerging markets, though many bigger multinationals are also suffering from slower growth in Europe and other developed markets. The foreign exchange effect also provides a boost to some of those companies; as the dollar weakens those stocks tend to fare a bit better than their peers.

Certain stocks that offer exposure to Chinese economic growth are also starting to perform better, thanks to Beijing’s massive stimulus program. For instance, I own Las Vegas Sands Corp (NYSE: LVS), which will continue to benefit from this trend.

I’ve never completely believed in decoupling [the theory that at some point domestic demand will reduce emerging economies’ dependence on developed markets]. The consumer drives two-thirds of the US economy, whereas developing economies still rely on industry for a great deal of growth. In other words, the US consumer will remain a key driver of export-based economies. I wouldn’t expect emerging markets to post massive growth without the US economy improving. For better or worse, the US is still the world’s largest consumer economy.

It’s often been said that high-end luxury names have defensive qualities. Do you find that to be true?

There are sort of two kinds of luxury names.

The first group includes companies such as Burberry Group (London: BRBY) and LVMH Moët Hennessy Louis Vuitton (Paris: MC, OTC: LVUMY) that offer true luxury items and products where the high-end consumer is more emotionally driven than economically driven. The performance of these names relates more to stock prices and general feeling than anything else.

What I’m more concerned about are names levered to the so-called aspirational customer. These luxury brands relied on middle-income consumers who were all too willing to tap their home equity and spend more than they could realistically afford to own the nicer things in life. These brands face large numbers of customers that potentially won’t purchase their products as frequently or at the same price point as before.

A lot of companies that fall into this bucket will have to cut prices significantly on the next season or two. And although it’s a good strategy to reconnect with the value part of the price-value equation, not every company will succeed. Even if a company cuts its prices by 30 percent, that doesn’t necessarily translate to a 30 percent increase in sales volume. In apparel and other areas where the price point is on its way down, investors should focus on companies with competitive advantages that will come out ahead, even as the size of the overall pie shrinks.

It’s important to look at average price points. Take denim, for example. Every year companies kept raising the price and launching more-expensive versions of the product. That strategy of growth via average selling price won’t be as effective going forward.

Where should investors look if they want to bet on a consumer discretionary name?

I break the sector into four buckets: retail, consumer services, media and durables.

Automobiles, houses and refrigerators are all products that consumers rely on credit to buy; even if there’s pent up demand, sales won’t pick up until banks are more willing to lend and consumers are more willing to borrow, which typically occurs later in the cycle. On the way down, smaller-ticket and habitual purchases are your best bet; names in the food industry tend to hold up well.

When demand shows signs of bottoming, retailers whose prices are a bit lower tend to be the first to show signs of life. Restaurants generally fall into this category. Investors might also look into some travel-related stocks–casinos, cruise lines and the like–but only as a tentative play; identifying a bottom is exceedingly difficult, and you don’t want to bet the ranch. The last thing that people feel comfortable spending on and borrowing for is a house.

Generally speaking, that encapsulates the gradual rotation through those different buckets and what I expect to happen as conditions improve.

As the prospects for growth have improved and consumer credit issues have normalized, I’m becoming a bit more comfortable with some longer-cycle areas in the consumer space. If you look at the weightings of my fund, you’ll see that I’ve upped my exposure to durables and retail, compared to a few quarters ago.

We’re definitely seeing the classic kind of early-cycle trade; as the rotation process continues, investors should move to areas where improved expectations aren’t fully reflected in the stock prices.