Israel Assets to Outperform Regardless of Election Outcome

The Bank of Israel just kept rates steady at 0.25%, as expected. Tomorrow, voters will elect the next government and polls suggest it’s a toss-up. Regardless of the election outcome, we believe strong economic fundamentals will allow Israeli assets to outperform this year.  

POLITICAL OUTLOOK

Netanyahu called early elections to take place this Tuesday. Elections were not due until November 2019. No government has served a full 4-year term since the 1984-1988 government of national unity. Over forty parties will take part.

The current government coalition is made up of 5 parties that hold a total of 61 seats in the 120-seat Knesset. Seats are awarded in proportion to the share of the national vote. A party needs to win a minimum of 3.25% of the vote to win one seat in the Knesset. The party with the most seats has 42 days to form a party.

Arab citizens represent nearly a fifth of Israel’s 5.8 mln eligible voters. They are represented by four small Arab parties that have never joined a ruling coalition. Nearly 5 mln Palestinians in the occupied territories are not Israeli citizens and so cannot vote.

The top challenger to Netanyahu is Benny Gantz. He is a former general and IDF leader that founded the so-called Blue and White bloc along with other generals and military officers. He is allied with Yair Lapid, leader of the centrist 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.

The current government at its strongest held 66 seats made up of six parties: Likud (30 seats), Kulanu (10), Jewish Home (8), Shas (7), UTJ (6), and Yisrael Beiteinu (5). Yisrael Beiteinu, led by Avigdor Lieberman, left the government in November to protest the ceasefire in Gaza. That left the coalition with a razor-thin 61 seat majority. According to recent polls, both Likud and Blue and White would likely win 30 seats each. What’s key then is how the allied parties fare.

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 remains 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. Only then can Mandelblit file charges.

Netanyahu’s popularity remains surprisingly high despite the corruption charges. This could be due to a variety of factors, including the transfer of the US embassy to Jerusalem, the controversial nation-state law that was passed, and the recent US recognition of Israeli claims to the Golan Heights. This is Netanyahu’s third consecutive term since 2009 and fourth overall. If he wins, he would overtake David Ben-Gurion as the longest-serving Israeli Prime Minister.

 

A BRIEF HISTORY LESSON

Benjamin Netanyahu has been Prime Minister since 2009. Prior to that, he served a term as the youngest Prime Minister ever from 1996-1999 before losing to Ehud Barak. Netanyahu later served in Ariel Sharon’s government, first as Foreign Affairs Minister (2002-2003) and then as Finance Minister (2003-2005). He took over leadership of the Likud party when Sharon left to form his Kadima party in December 2005.

Controversy is no stranger to Netanyahu. During his first term, Netanyahu was investigated several times on charges of fraud and breach of trust. He denied all wrongdoing and was never charged. Netanyahu could become the first sitting Prime Minister to be formally charged. First lady Sarah Netanyahu is also under investigation.

Netanyahu is by no means the first Israeli leader to come under ethical scrutiny. Ariel Sharon was suspected of receiving bribes in the late 1990s in what became known as the “Greek Island Affair.” Prosecutors recommended bringing charges, but the Attorney General felt there was insufficient evidence to do so. Prime Minister Ehud Olmert came under criminal investigation in January 2007 for possible corruption during his tenure as Finance Minister from 2005-2006. This was quickly followed by several other criminal investigations. After leaving office in 2009, Olmert was eventually convicted on two counts of bribery in March 2014 and sentenced to prison and fined.

 

ECONOMIC OUTLOOK

The economy is in solid shape. GDP growth is forecast by the IMF at 3.5% in 2019 and 3.1% in 2020 vs. 3.3% in 2018. GDP rose 2.8% y/y in Q4, the weakest since Q3 2017. Monthly data so far suggest growth decelerated a bit in Q1 and so we see some downside risks to the growth forecasts.

Price pressures remain low. CPI rose 1.2% y/y in February, matching the highest rate since July 2018 but still well within the 1-3% target range. PPI is showing deflation, contracting y/y for the second straight month to -0.5% y/y in February. This portends potential deceleration in CPI inflation. March inflation data will be reported on April 15

For now, the Bank of Israel appears to be in no hurry to hike rates. 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.

The central bank adjusted its forecasts down at today’s meeting. It cut its growth forecast for this year from 3.4% to 3.2%, blaming weak exports amidst slowing global trade. The bank kept their forecast for end-2019 policy rate at 0.5% but cut the end-2020 forecast from 1.25% to 1.0%.

The external accounts remain in good shape. The current account surplus was 3% of GDP in 2018, and the IMF expects the surplus to narrow modestly to 2.3% of GDP in 2019 before improving back to 3% in 2020. Export growth has slowed in recent months. No wonder policymakers continue to push back against a strong shekel.

Foreign reserves remain at record highs due to the FX intervention program. At $118.2 bln in March, reserves cover over 11 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 recently 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 4.3% YTD vs. USD, and is the best DM performer. Due to low external vulnerabilities and strong fundamentals, we believe the shekel will continue to outperform.

USD/ILS is trading at its lowest level since September. That September 2018 low just below 3.56 lies close, as does the May 2018 low near 3.5435. A clean break below the 3.5820 area is needed to set up a test of the January 2018 low near 3.3795.

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 11.6% YTD vs. 15.6% for MSCI 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 -38 bp YTD. This is behind only the best DM performers Greece (-83 bp), Portugal (-49 bp), Australia (-44 bp), and Hong Kong (-39 bp) and tied with New Zealand (-38 bp). With inflation likely to remain low and the central bank likely to tilt dovish, we think Israeli bonds will continue to outperform.