The German parliament approved the third bailout for Greece on Wednesday, putting the country back firmly within the eurozone. You'd expect markets to stage a relief rally, but no sooner has the Greek crisis been contained (again) than the effect of China's weakening yuan on Europe is becoming more and more obvious.
As usual, the equity markets have been the first to react. The Euro Stoxx 50 index of blue chip stocks in 12 eurozone member states has lost more than 5% since the People's Bank of China announced last week that it changed the way it calculates the exchange rate, sending the yuan sharply lower. Germany's DAX index lost nearly 6%.
Capital flows data showed that as late as last week investors were still pouring money into European equities, but China's move may be a game-changer for the asset class, at least for the short term. Investors liked the fact that European companies have had their best earnings season in years, and this was mainly due to the weak euro translating in better exports.
China's move could throw a spanner in the works in two ways: weakening purchasing power within China due to a weaker yuan could mean fewer goods from Europe sold there, while the weaker yuan could also pose a competitive threat for the weaker euro in other markets, especially in emerging economies.
No wonder the DAX has been hit so badly. China is the world's biggest car market, and they loved those Mercedes and BMWs, and even the Volkswagens. But weaker domestic demand was already hurting car sales there, which increased by only 4.8% in the first half of this year compared with an annual growth of 10% last year and an average rate of growth of around 22% between 2006 and 2013.
"Slower growth, a weaker yuan and rising competition from Chinese car makers are likely to constrain demand for foreign cars," says Alberto Gallo, head of macro credit research at RBS.
One way to play this trend could be to take a long position in Fiat Chrysler (FCAU) vs. a short one in Volkswagen (VLKAY), because Fiat Chrysler's presence is focused on developed markets like the U.S. and Europe. It has less exposure to China and the wider emerging markets than Volkswagen, for which they account for more than 40% of vehicle deliveries.
Another advantage of Fiat is that its fundamentals have improved, with sales growing by more than 20% in the second quarter this year and net debt/EBITDA stabilizing around 1.3x-1.5x, Gallo added.
HSBC strategist Robert Parkes notes that the most exposed European sectors to China, such as materials, autos, consumer durables or capital goods, "have fallen dramatically out of favour."
Source: HSBC Research
Other European companies with relatively high exposure to China via sales are miners Anglo American (AAUKY), Antofagasta (ANFGY) and BHP Billiton (BHP), which strategists at HSBC rate as a Hold, or industrial goods producers Kone (KNYJY), Metso (MXCYY) SKF AB (SKUFF), on which their recommendation is Reduce.
For a while, it looked like overcoming the Greek debt crisis would be the most difficult challenge of the year for the eurozone.
But now, the Chinese yuan devaluation may upset the European Central Bank's efforts to render the eurozone's economy more competitive through a weaker euro. Policymakers may come to regret the lack of some drama weighing on the exchange rate.