Affirming Israeli Equity and Bond Market Over-Weighting After Mid-March National Ballot

Market optimism appears riven and hesitant in the wake of the center-right Likud party’s unanticipated victory in Israeli general elections last month.  Indeed, Israeli government bonds, which are returning just 2.9 percent thus far in 2015 (denominated in US dollars), earned investors virtually equivalent rates (1.4 and 1.5 percent, respectively) in the run-up to and after March 17, the day of the nationwide ballot.  A rebound in the shekel’s fortunes explains much of the single-digit positive performance of Israeli sovereign debt mirrored by the downward shift in the yield curve.

Israeli Real GDP, Leading Economic Indicators and Tel Aviv 100 Positive-Adjusted Price/Earnings Ratio

Unadjusted for inflation, the shekel (ILS), as calculated by Barclays trade weighted ILS indices, is overvalued 2.9 percent (a 317 basis point turnaround from the same year-to-date period a year ago) against a basket of currencies the corresponding countries of which are trading partners of Israel, whereas the unit’s real (revised for living costs) trade-weighted exchange rate has been undervalued fractionally (-0.3 percent) since the end of last year, a 177 basis point reversal from the same period a year ago.  Pairwise versus the US dollar (USD), ILS traded stably in a slender ILS3.8 to ILS4.1 range, helping underpin returns of fixed income issuance.

Yet, the country’s equity market, the Tel-Aviv (TA) stock exchange (the behavior of which is gauged by the TA-100 index), has surged a remarkable 7.1 percent since the mid-March vote by contrast with the 3.8 percent total return it garnered in USD prior to the poll.  TA-100’s impressive double-digit composite gain of eleven percent compares auspiciously to both emerging and developed shares market performance so far this year, rating Israeli shares eleventh strongest worldwide.

Israeli Sovereign Shahar Yield Curve

While an acutely fragmented domestic political environment might limit the upside to investor confidence in the sovereign debt market, Prime Minister Benjamin Netanyahu is likely to reject the formation of a grand coalition with the center-left Zionist Union and configure a reasonably stable ruling alliance that, in spite of some modest concessions to populist demands of Likud’s subordinate coalition partners, should accord him sufficient latitude to advance his economic liberalization and tax relief agenda.  Politics and policymaking issues aside and in the absence of a fresh outbreak of hostilities on any of Israel’s borders, projected macroeconomic and financial trends presage narrowly augmented returns of Israeli debt and equities alike in the months immediately ahead.

Even though the Israeli economy capitulated to deflationary pressures five months ago, the Israeli economy is forecast to grow 3.4 percent this year, strengthening to 3.7 percent in 2016, assuming its territory abutting any of its neighbors (like Palestinian-controlled Gaza and the West Bank) does not fall prey to another round of terrorist attacks.  Anticipated modest declines in joblessness in 2015 and 2016 should reinforce the improving pattern in private consumption arising from elevated real disposable personal income as a result of expected additional tax reductions and declining living costs.  Exports too are likely to contribute to a pickup in economic activity thanks to the shekel’s steep, nine-month depreciation against the US dollar.  Consequently, the current account surplus as a proportion of nominal GDP will steady at three percent this year before swelling to 3.5 percent in 2016.

Continued low credit costs, sustained by the Bank of Israel’s highly accommodative monetary policy (eleven key lending rate cuts in little more than three and a half years to its current level of 0.10 percent) that aims to forestall deflation from accelerating, should impart some impetus to fixed capital formation, reflected in an expansion of plant and equipment by the private sector.  The only drag on a projected expansion in real GDP will probably emanate from government spending as the incoming team at the finance ministry pursues a contraction of public spending to accommodate a reduction of levies for fostering higher national productivity.

The Tel Aviv stock exchange’s positive-adjusted, one-year forward price-earnings multiple (p/e) of 11.9x in shekel terms is comparatively inexpensive when measured against that of Hungary (13.6x), Poland (14.1x), the Czech Republic (14.4x), South Africa (17.8x), Slovakia (14.9x) and Slovenia (12.1x), but expensive vis-à-vis Russia’s 6.2x and Turkey’s 10.1x forward multiples.  Moreover, TA’s p/e firmly understates its roughly twenty-one year record high (31.8x) and historical average (17.0x).  Lastly, compared with its overall bellwether – the MSCI Eastern Europe, Middle East and Africa index, the TA-100 is marginally undervalued on a relative basis, bolstering prospects for multiple expansion as do the absolute valuation comparisons.

Notwithstanding the possibility of deepening deflationary pressures and renewed political fragility domestically, we remain confident in Israel’s resilience to not just absorb and endure random exogenous shocks of various origins, but surmount adversity as well.  Inarguably, geographical circumstances disfavor long-term peace in the Middle East for some time to come – keeping the Israeli Defense Forces on constant alert to foreign threats of cross-border violence directed at the civilian population.

Israeli Shekel Real and Nominal Effective, Trade-Weighted Indices and Spot Exchange Rate

Spreading sectarian strife in Yemen, Syria, and Iraq render the situation in the region extremely unpredictable with virtually no likelihood of resolution anytime in the immediate future.  Fortuitously, Cairo is as eager as Jerusalem to suppress Gaza militancy.  Israel’s military advantage in retaining control of the Golan Heights provides its citizenry with a modicum of protection against terrorist attacks from guerrillas based in Syria and Lebanon not to mention the fact that most of eastern Israel borders Jordan, helping to shelter the Zionist state from direct interaction with the conflict Iraq.

Nevertheless, conciliatory relations between Israel and some of its neighbors remain intact regardless of the visceral animosity that Al-Qaeda, ISIS (Islamic State of Iraq and Syria), Hamas, Hezbollah and other militant groups reserve for Israel as well as the US.  Jerusalem’s trepidations over regional instability seem justifiable especially if Islamic fundamentalists of either the Sunni or Shia sect were to vanquish their opponents entirely in either Yemen, Syria or Iraq and secure a foothold from where they could foment instability across the Arabian peninsula – from Saudi Arabia to Oman, the emirates and Kuwait.

For now, though, the intense denominational conflict should confine the struggle for state control to Iraq, Syria and Yemen for the foreseeable future.  Although an abundance of security worries is still a major distraction to the authorities in Jerusalem, accommodative monetary and restrained fiscal policies in tandem with relatively promising macroeconomic trends, attractive stock market valuations and the anticipated formation of a stable center-right coalition government convince Global Markets Intelligence (GMI) that the rally in Israeli debt and shares markets has the potential to advance further irrespective of all the risks.

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