* Pan-European index drops 2.5 pct on first day of 2016
* Germany's DAX down 4.3 as weak China data hits markets
* Ferrari outperforms car sector on Milan debut
* Euro STOXX 50 Volatility Index rises (Adds closing prices)
By Sudip Kar-Gupta and Danilo Masoni
LONDON/MILAN, Jan 4 (Reuters) - European shares fell sharply on Monday, the first trading day of 2016, as weak Chinese data weighed on world stock markets.
The pan-European FTSEurofirst 300 index lost 2.5 percent, its biggest one-day drop since a 3.3 percent fall on Dec. 3, while the euro zone's Euro STOXX 50 index fell 3.1 percent and Germany's DAX slumped 4.3 percent.
China's factory activity contracted for the 10th straight month in December and the decline accelerated compared with November, a private survey showed.
China's benchmark CSI300 share index tumbling 7 percent on Monday, prompting the stock exchange to halt trading for the rest of the day.
"This year got off on the wrong foot because of China," said ActivTrades chief market analyst Carlo Alberto De Casa.
All sectors were in negative territory with auto stocks , for whom China is a key overseas market, leading the way with a fall of 4.5 percent.
But shares in Ferrari edged up 0.5 percent in their Milan debut as the luxury sports car maker completed its spin-off from parent Fiat Chrysler. De Casa said the listing of such an important brand could be a good sign for Italy after many delistings.
Oil stocks extended losses to fall 1.5 percent as crude prices turned lower late in the session following an unexpected rise in U.S. crude stocks. The sector however outperformed as oil prices remain above recent lows as tensions in the Middle East escalated following Saudi Arabia's execution of a prominent Shi'ite cleric. Market volatility increased, with the Euro STOXX 50 Volatility Index gaining ground.
JP Morgan's equity strategist Mislav Matejka said he would stay "overweight" on euro zone equities, given signs of an economic recovery in the region. But he was more cautious on equities overall, citing tensions in the credit market and a weakening in the U.S. stock market.
"We would look to use any strength as an opportunity to reduce equity allocation," Matejka said. He advocated selling out on any move up.
Telecoms were also in focus, with French conglomerate Bouygues rising 1.7 percent after a media report that Orange was closer to buying Bouygues' telecoms arm for 10 billion euros.
Air France KLM shares rose 3.3 percent after Bank of America Merrill Lynch upgraded its rating on the stock to "buy".
Today's European research round-up (Editing by Alison Williams and Richard Balmforth)