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European shares fell and the euro neared a two-year low on Tuesday as fresh data revealed Europe's debt crisis had caused a sharp slowdown in German factory activity, although an improvement in China's manufacturing sector lifted commodities.
The data also showed the private sector across the whole 17-nation euro area shrank for a sixth straight month in July, mainly due to the weakness in manufacturing, putting the region on track to fall back into recession.
"Companies seem to be expecting things to deteriorate further in the coming months," said Chris Williamson, chief economist at Markit, which compiled the euro zone data.
The euro fell below $1.21 to the dollar after the data, to be down 0.2 percent at $1.2090 and just above a 25-month low of $1.2067 hit on Monday when concerns about Spain sparked a broad sell-off in financial markets.
The slowdown in German industrial activity was the biggest surprise for market analysts, contracting in July at its fastest pace in three years.
The Markit Purchasing Manager's Index (PMI) for German factories slid to 43.3 from 45.0 last month, below the consensus forecast in a Reuters poll of 45.3 and well under the 50 mark that separates growth from contraction.
"The German manufacturing sector has been one of the key elements of the euro zone recovery and to see it contracting at this rate is really quite worrying," Williamson said.CHINA SUPPORT
Equity markets were less affected by the data having started the day in a positive mood after a similar survey of factory activity in China pointed to improving conditions and easing fears of a sharp slowdown in the world's No. 2 economy.
The HSBC PMI for China rose to 49.5 in July from 48.2 in June, its fastest growth rate in nine months, with a strong rise in new export orders reported.
"Today's encouraging PMI data add to the feeling that recent policy stimulus is working," said Qinwei Wang, China economist at Capital Economics.
Asian shares inched higher on the Chinese data but the weaker European session left the MSCI world equity index slightly lower at 305.77 points after it lost 1.7 percent on Monday.
U.S. stock index futures pointed to a lower open on Wall Street.
The FTSEurofirst 300 index of top European shares initially gained on the Chinese numbers but the data on the euro zone slowdown coupled with ongoing worries about Spain's fiscal problems turned the market around, leaving it down 0.1 percent at 1,023.40 points.
The index had hit a three-week low on Monday when investors fled all riskier assets on fears that growing financial problems within regional governments in Spain would force the country into seeking a full scale sovereign bailout.
Spanish five-year government bond yields rose in line with 10-year bonds on Tuesday in a sign that markets were preparing for the risk of a big credit event.
The five-year Spanish bond yield was up 16 basis points at 7.59 percent, while 10-year yields were up 10 bps higher at 7.6 percent.
The government had to pay the second highest yield on short-term debt since the birth of the euro at an auction on Tuesday, reflecting the belief that it will need international aid that regional partners can barely afford.
German bond yields were also rising after ratings agency Moody's revised down its outlook for the country, along with the Netherlands and Luxembourg, citing the costs associated with a potential Greek exit from the euro zone and the possible need to provide support to both Spain and Italy.
"Given the trade and financial linkages that Germany has with a shaky euro zone, that news possibly shouldn't come as any surprise," said Mike Ingram, market analyst at BGC Partners.
The warning did slightly increase the attractiveness of U.S. Treasuries compared to the equivalent German Bunds, keeping yields on 10-year notes near their historic lows of 1.3977 percent.
"With growing worries over the euro zone as an entity investors seem to prefer Treasuries over Bunds at this juncture," said RIA Capital Markets bond strategist Nick Stamenkovic.
Commodity markets took their lead from the signs of improvement in China's giant manufacturing sector which is world's largest consumer of many industrial products.
Three-month copper on the London Metal Exchange jumped 1.3 percent to $7,494 per tonne, while Brent crude gained 51 cents to $103.77 a barrel, though it was off earlier highs above $104.
U.S. crude gained 36 cents to trade at $88.50.
"China is the biggest driver of oil demand and its overall oil appetite does not seem to have suffered so much, as it builds up infrastructure and crude stockpiles," said Tony Nunan, a Tokyo-based risk manager at Mitsubishi Corp.