Israel Assets to Outperform Despite Election Do-Over

Israeli voters will go the polls again in September. Regardless of the election outcome, we believe strong economic fundamentals will allow Israeli assets to outperform this year.

POLITICAL OUTLOOK

Netanyahu called early elections that took place on April 9. Elections were not due until November 2019. The party with the most seats has 42 days to form a party. After Netanyahu’s failure to form a government within that allotted time, he dissolved the Knesset rather than give rival Blue and White the opportunity to form a government. Fresh elections will be held September 17.

The equivalent of the old governing coalition could not be reproduced. Yisrael Beiteinu leader Avigdor Lieberman withheld his party’s support, denying Netanyahu’s right-wing coalition a majority of 61 seats in the 120-seat Knesset. During this time, Netanyahu was also reportedly trying to drum up support for an immunity bill that would allow him to avoid prosecution while in office. This news was met with protests and outrage that may ultimately harm him at the polls.

The top challenger to Likud remains Blue and White. Leader Benny Gantz is a former general and IDF leader that founded this new bloc along with other generals and military officers. He is allied with Yair Lapid, leader of the former centrist party Yesh Atid. If Blue and White were to win, it has been agreed that Gantz would serve as Prime Minister for the first two and a half years and Lapid the last two and a half years.

Recent polls suggest Yisrael Beiteinu would increase its seat count from 5 to 8, making it the third-largest behind Likud (36 seats projected) and Blue and White (34 seats projected). Using these projections, the right-wing parties would only likely win 59 seats, falling short again of the 61 needed to form a majority. And so, it appears that Lieberman will become an even bigger kingmaker than before this fall (see A Brief History Lesson below).

We do not think economic policies would be considerably different if Blue and White were to win. Orthodox (pun intended) economic policy has been embraced by both the center-right and center-left. The main area of difference would likely be in Israeli-Palestinian and Israeli-US relations. Likud has tacked far-right in terms of settlements and has allied closely with President Trump.

Prime Minister Netanyahu will remain under investigation. In February, Attorney General Avihai Mandelblit drafted an indictment against Netanyahu that would charge him with bribery, fraud, and breach of trust. One charge has to do with receiving gifts in exchange for political favors, another has to do with giving political favors for a publisher in exchange for favorable news coverage. Before the indictment can be filed, Netanyahu is entitled to a hearing to present his side of the story. This hearing will be held in October. That means a cloud will hang over Netanyahu going into the September vote.

 

A BRIEF HISTORY LESSON

Avigdor Lieberman will likely hold the key to the next Israeli government. He grew up in what is now Moldova and emigrated to Israel with his family in 1978. He became active in politics in 1988, working as a member of Likud with Benjamin Netanyahu. From 1993-1996, Lieberman served as Director-General of Likud and helped Netanyahu win his first term as the youngest Israeli Prime Minister ever from 1996-1999. Lieberman served as Director-General of the Prime Minister’s office under Netanyahu.

In 1997, Lieberman resigned from Likud after Netanyahu granted what he believed to be too many concessions to the Palestinians. Lieberman then formed Yisrael Beiteinu in 1999 as a party meant to represent Russian immigrants that favored a hardline approach to Palestine. After the January 2003 elections, Lieberman went on to serve in Prime Minister Ariel Sharon’s cabinet as Transport Minister from February 2003 to May 2004. He was dismissed from the cabinet due to his opposition Sharon’s policies in Gaza. Yisrael Beiteinu then left the government in June 2004 in protest.

After March 2006 elections, Lieberman was in opposition before serving as Deputy Prime Minister in Ehud Olmert’s government from 2006-2008. Lieberman resigned his cabinet position and left the ruling coalition in January 2008 due to his opposition to peace talks. Yisrael Beiteinu was the third-largest party after the February 2009 elections and entered into coalition with Netanyahu. He was appointed Deputy Prime Minister and Minister of Foreign Affairs.

Likud and Yisrael Beiteinu ran together in the January 2013 elections. Together, the two won 31 seats (18 seats for Likud and 13 for Yisrael Beiteinu), down from 42 (27 seats for Likud and 15 for Yisrael Beiteinu) in 2009 elections. Early elections were held in March 2015 and won by Likud (30 seats) even as Yisrael Beiteinu ran separately again (6 seats). Yisrael Beiteinu later joined the ruling coalition in May 2016 and Lieberman became Defense Minister for Netanyahu from 2016-2018.

Last November, Lieberman stepped down from the cabinet and left the coalition to protest a proposed ceasefire with Hamas. This spring, he refused to join the Likud coalition after he was unable to engineer the elimination of military draft exemptions for the Ultra-Orthodox. In the April elections, Yisrael Beiteinu won 5 seats, down from 6 in 2015, while Likud won 35 seats, up from 30 in 2015.

It’s clear from their history that Netanyahu and Lieberman have had a long and complicated relationship. However, it’s also clear that Lieberman will not hesitate to leverage his position as a possible kingmaker this fall.   Whether that means siding with Likud or with rival Blue and White remains to be seen.

 

ECONOMIC OUTLOOK

The economy is in solid shape. GDP growth is forecast by the IMF at 3.3% in both 2019 and 2020 vs. 3.4% in 2018. GDP rose 3.3% y/y in Q1, the strongest since Q2 2018. Monthly data so far suggest growth decelerated a bit in Q2 and so we see very modest downside risks to the growth forecasts.

Price pressures remain low. CPI rose 1.3% y/y in April, near the cycle high of 1.4% in March but still near the bottom of the 1-3% target range. PPI inflation remains low, suggesting little in the way of pipeline price pressures. May inflation data will be reported June 14.

For now, the Bank of Israel appears to be in no hurry to hike rates again. It has been on hold at 0.25% since the first (and last) 15 bp hike back in November by Interim Governor Nadine Baudot-Tratjenberg. Since then, Amir Yaron was named Governor and we suspect he will err on the side of dovishness going forward.

Minutes from the May 20 meeting showed one dissent in favor of a hike. Officials said then that the strong shekel was the “main factor” that’s keeping inflation low. Next policy meeting is July 8, no change is expected then.

The external accounts are worsening modestly. The current account surplus was 3% of GDP in 2018, and the IMF expects the surplus to narrow to 1.7% of GDP in 2019 and 1.4% in 2020. Export growth has slowed and even contracting y/y in some of the recent months.

Foreign reserves remain at record highs due to the FX intervention program. At $118.7 bln in April, reserves cover nearly 11 1/2 months of import and are more than 3 times larger than the stock of short-term external debt. Lastly, Israel’s Net International Investment Position (NNIP) remains a relatively high at 36%. Thus, external vulnerabilities are relatively low.

 

INVESTMENT OUTLOOK

To be consistent with MSCI classifications, we have switched Israel from EM to DM status. Israel entered our DM model universe at AA-/Aa3/AA-, matching S&P but above Moody’s and Fitch at A1 and A+, respectively. Those latter two are subject to upgrade potential.

The shekel is outperforming after a so-so 2017. Last year, ILS fell -7.1% vs. USD and was ahead of only the worst DM performers AUD (-9.7%), CAD (-7.8%), and SEK (-7.6%). So far in 2019, ILS is up 3.4% YTD vs. USD, and is the best DM performer. The next best is CAD, up 1.6% YTD. Due to low external vulnerabilities and strong fundamentals, we believe the shekel will continue to outperform.

Israeli equities are underperforming after outperforming in 2018. In 2018, MSCI Israel was -6.6% vs. -11.6% for MSCI DM. So far this year, MSCI Israel is up 3.0% YTD vs. 11.2% for MSCI World (DM). We expect equities to start outperforming, as our DM Equity Allocation Model has Israel at OVERWEIGHT.

Israeli bonds have outperformed. The yield on 10-year local currency government bonds is -73 bp YTD. This is behind only the best DM performers Greece (-139 bp), Portugal (-99 bp), Australia (-82 bp), and Spain (-75 bp). With inflation likely to remain low and the central bank likely to remain hold for now, we think Israeli bonds will continue to outperform.