China's slowdown threatens the euro zone core more than the fragile South

By Jamie McGeever

LONDON (Reuters) - Few parts of the world will remain unscathed by the plunging stock markets and economic slowdown rocking China, but the companies of Europe's soft underbelly may weather it best.

Countries comprising the euro zone's periphery, such as Spain, Italy and Portugal, have relatively small exposure to the world's growth engine. Core countries like Germany, France and The Netherlands have much deeper links.

Strong demand from China has fuelled the boom in Germany's German auto industry, the success of France's luxury and fashion empires and solid growth in the Dutch and Finnish chemicals and capital goods sectors. Investment by their companies has grown accordingly.

But that demand may be cooling. China's factory activity shrank in July at the fastest rate in two years, the country's stock markets have slumped 30 percent since mid-June and growth could soon fall below 7 percent for the first time since early 2009.

"Germany has products China wants. But we've got slowing global trade, slowing global growth, and Germany has already benefited from its currency weakness advantage," said Stewart Richardson, partner at RMG Wealth Management in London."

"Germany suffers if China suffers. So on European equities, the periphery outperforms Germany," he said.

European stocks have been the destination of choice for investors this year, with cash flowing in from emerging markets and the United States. A net $80 billion has gone into European equity funds this year, according to Bank of America Merrill Lynch.

The difference between core and peripheral euro zone countries' exposure to China is clear from trade flows.

Around 8 percent of Germany's exports go to China and about 5 percent of both France and Finland's, according to Marc Chandler, head of global currency strategy at Brown Brothers Harriman in New York.

Compare that with the periphery: 3 percent of Italy's overseas sales go to China, around 2.5 percent of Spain and Ireland's, and only 2 percent of Portugal's.

Of the top 37 European companies' exposed to China in a list drawn up by UBS, only 16 are from the euro zone. Of those, 15 are from core countries Germany, France, Finland and The Netherlands.

Spanish retailer Inditex is the only company from the so-called euro zone periphery to appear on the list. And it is near the bottom, with only 10 percent of revenues coming from China.

ECB FACTOR

German automaker Daimler posted a 54 percent surge in second-quarter operating profit, to a record high of 3.8 billion euros, as sales of trucks and new luxury car model launches helped it defy a slowdown in China.

It remains to be seen how long it can defy gravity, though. Rival Audi last week lowered its global sales forecast because of slumping demand in China, the luxury-car brand's biggest market.

China's impact on European government bond markets has been muddied by the Greek crisis, which ultimately saw agreement between Athens and its creditors that should lead to a third multi-billion-euro aid programme for the cash-strapped nation.

July also saw the biggest monthly fall in Chinese stocks since the global financial crisis in late 2008.

In that roller-coaster month, the price of peripheral euro zone countries' bonds rose faster than Germany's, narrowing yield spreads. The premium demanded by investors to hold Spanish bonds over German bonds fell to 110 basis points from 165 basis points at the end of June.

And it's worth noting that the peripheral countries are also the principle direct beneficiaries of the European Central Bank's 1 trillion-euro bond-buying stimulus programme, which will run through September next year.

But to paraphrase the adage about the United States and the rest of the world, If China sneezes, won't everyone else catch a cold? And within Europe, if Germany sneezes, won't the rest of the continent catch a cold?

Fahd Rachidy, partner and chief investment officer at Sparrows Capital in London, played down the current economic relative outperformance of some peripheral countries like Spain and Ireland. Much of that just reflects their collapse in labour costs vis-à-vis the rest of the euro zone, he said.

"If Germany performs poorly because of the Chinese impact on international trade, then the periphery will follow as most of the intra-euro zone exchanges are with Germany," said

"Extrapolating the Chinese situation to infer that investors favour the periphery over the core is a bit far-fetched," he said.

(Reporting by Jamie McGeever; Additional reporting by Atul Prakash; Editing by Larry King)