With investors fixated on the open-ended crisis in Europe, fretting about how it may affect their investments here in the United States, they may be overlooking another emerging trouble spot. Halfway around the world, the Chinese economy has begun to slow, and the duration and depth of the current slowdown could have a clear impact on the rest of the world’s economies — and U.S. stocks.

In short, a soft landing would be well-tolerated by the global economy. A hard landing could be devastating. Chinese government officials have begun to take steps to recharge the economy, including a cut in inter-bank lending rates, but they may have less control over this massive ship than they think.

Soft and getting softer
Recent data points out of China bring to mind the old adage that “when the United States sneezes, the rest of the world catches a cold.” But this time, it’s Europe that is making China reach for the Kleenex. European economies have slowed sharply in recent months, with most of them now in recession. Across the continent, it looks as of the euro zone will contract by 0.6% in the fourth quarter. As Europe accounts for 30% of all of China’s exports, making it the country’s largest trading partner, it’s no surprise Chinese factories are starting to feel a slowdown.

On the surface, China’s export sector looks OK. Exports rose 10.9% in November, compared with a year earlier. Yet that’s down from 15.9% in October. Exports are growing, but at a rapidly decelerating rate.

Speaking at a news conference recenly, Iwan Azis, an official with the Asia Development Bank (ADB), told an audience in Hong Kong that “things are changing very rapidly — not just weekly and daily, but hourly.” The ADB lowered its outlook for regional economic growth in 2012 from 7.5% to 7.2%, but cautioned that the rate could actually be closer to 5% if European economies remain weak in 2012.

The wildcard is China, which is a major trading partner of virtually every other country in Asia. As China feels the effects of a receding Europe, its economy will need fewer intermediate goods that Asian neighbors provide, possibly setting up a vicious cycle of negative feedback loops. That’s why these next six to eight weeks are crucial. Coming data points will reveal just how much of a slowdown investors should expect.

What does it mean for the U.S. economy — and your stocks? Plenty. China is our third-largest export market after Canada and Mexico, and we’re on track to ship $100 billion worth of goods to China in 2011. That’s up from $92 billion in 2010 and $69.5 billion in 2009.  In fact, from 2000 to 2010, U.S. exports to China grew by 468%, which was more than eight times the 56% growth in exports to the rest of the world. Items such as Caterpillar’s (NYSE: CAT) excavators, Intel’s (Nasdaq: INTC) processors, GE’s (NYSE: GE) turbines, Smithfield Foods’ (NYSE: SFD) pork products and Tiffany’s (NYSE: TIF) jewelry are all selling in increasing volumes to China. A slowing Chinese economy figures to blunt the steady export growth.

But the psychological result of a slowing China could be even greater. That country needs to keep generating robust economic growth to keep its restive population placated. Many citizens are frustrated by a stifling and corrupt bureaucracy, but have tolerated this as long as job opportunities and wages keep rising. Chinese policy makers fear an economic slowdown — and a possible uptick in unemployment — would spark social unrest. Moreover, China’s banks are said to be carrying a rising tide of defaulting loans on their books, a trend that would be exacerbated by an economic slowdown. A troubled Chinese financial sector would have ripple effects around the world.

Right now, most Wall Street economists predict the Chinese economy will expand by 8% or 9% in 2012. That’s starting to look unrealistic. If China’s growth cooled to 7%, then the U.S. economy would take the trade impact in stride, as it seems to handle all kinds of global blows these days. But a growth rate closer to 5%, which would lead to social instability and bank bailouts, is a scarier prospect, according to China watchers. This rate implies a global economy that will struggle to expand in 2012, as China had been expected to be the engine that powers global trade in the year ahead. This is just one more bullet that investors may have to dodge, and if China indeed slows at an accelerating pace, then it may be time to reduce your exposure to U.S. stocks.

Risks to Consider:  Predictions that the Chinese economy is on the cusp of a slowdown have been in place for a while, but have yet to materialize, so the most dire predictions may not come to pass.

Action to Take– > We live in a globally interconnected economy, so one trading bloc can inflate or deflate economic activity elsewhere at a rapid pace. Europe’s troubles threaten to drag China, the United States, Japan, Brazil and others down if the current troubles deepen. Even as you keep an eye on Europe, it’s important to stay focused on China and protect your investments accordingly.