New Bank of Israel Governor Likely to Lead to Firmer Shekel

The shekel traded at its weakest level since March 2017 this week. With inflation pressures rising, the incoming central bank Governor will likely start hiking rates and accepting a firmer exchange rate.POLITICAL OUTLOOK

Prime Minister Netanyahu remains under investigation. He has been questioned many times already by the police with regards to corruption. In February, the police said there was enough evidence to charge Netanyahu with bribery, fraud, and breach of trust in two separate cases. One has to do with receiving gifts in exchange for political favors, while the other has to do with giving political favors for a publisher in exchange for favorable news coverage. However, Attorney General Avichai Mandelblit has yet to decide whether to press charges or not.

Mandelblit recently revealed that another probe is in “very advanced stages.” This investigation pertains to allegations that Netanyahu improperly arranged for regulatory benefits for a telecoms company. This is after a third probe was launched regarding suspicious submarine purchases from Germany.

The current government coalition is made up of 6 parties that hold a total of 66 seats in the 120-seat Knesset. This is Netanyahu’s third consecutive term since 2009 and fourth overall. Yet by dominating Israeli politics for so long, Netanyahu has not designated a likely successor within his Likud party.

Netanyahu’s popularity is soaring. This could be due to a variety of factors, including the recent transfer of the US embassy to Jerusalem, the controversial nation-state law that was just passed, and the further isolation of regional rival Iran. According to recent polls, Likud would likely win 33-35 Knesset seats in the next election vs. 30 currently. Those same polls suggest that the Likud-led coalition would retain power with 66-67 seats out of 120 total.

General elections must be held by November 2019. No government has served a full 4-year term since the 1984-1988 government of national unity. With Netanyahu’s popularity on the rise, many expect early elections will be called in order to take advantage of this upswing.

Israel scores well in the World Bank’s Ease of Doing Business rankings (54 out of 190). The best components are resolving insolvency and protecting minority investors, while the worst are registering property and paying taxes. Israel does better in Transparency International’s Corruption Perceptions Index (32 out of 180 and tied with Brunei).

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.

The Supreme Court has ruled in the past that government ministers may not retain their posts once they are criminally indicted. However, it’s not clear if that applies to the Prime Minister himself. Indeed, Netanyahu could be the first sitting Prime Minister to be formally charged. First lady Sarah Netanyahu is also under investigation, and the situation remains fluid.

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 3.3% in 2018 and 3.5% in 2019 vs. 3.3% in 2017. GDP rose 4.1% y/y in Q1, the strongest since Q4 2016. Monthly data so far suggest growth decelerated a bit in Q2 but we still see upside risks to the growth forecasts.

Price pressures are rising. CPI rose 1.3% y/y in June, the highest since March 2014 and within the 1-3% target range for the first time since May 2014. PPI inflation has accelerated to 2.2% y/y in July, the highest since March 2017. This may portend further acceleration in CPI inflation. July inflation data will be reported on August 15

For now, the Bank of Israel appears to be in no hurry to hike rates. It has been on hold at 0.10% since the last 15 bp cut back in April 2015. The central bank said it will stay on hold until inflation is “entrenched” within the target range, but this is obviously open to interpretation. Bloomberg consensus sees the first hike coming sometime in Q1 2019.

Governor Karnit Flug recently announced that she would not seek a second five-year term when her current one ends November 12. She took over on an interim basis for Governor Stanley Fischer when he retired in July 2013, and later won a full term in October of that year. Netanyahu and Finance Minister Moshe Kahlon are tasked with finding her replacement. Press reports Martin Eichenbaum of Northwestern University has already turned down an offer to head up the central bank.

We believe the incoming central bank governor can make a strong statement to the markets by hiking rates early in their tenure. The easing cycle was started by Stanley Fischer, which was continued by Flug. With the economy robust and inflation picking up, it’s simply time to hike rates. Perhaps it will be as early as the first meeting to be chaired by the new Governor is November 26.

The external accounts remain in good shape. The current account surplus was 3% of GDP in 2017, and the IMF expects the surplus to narrow modestly to 2.6% of GDP in 2018 and 2.7% in 2019. Export growth has slowed in recent months, which is disappointing considering strong growth in the US and EU. No wonder policymakers are pushing back against a strong shekel.

Foreign reserves remain near record highs due to the FX intervention program. At $115.8 bln in July, reserves are only down slightly from the record high $117.6 bln in January. They cover 12 months of import and are 3 ½ times larger than the stock of short-term external debt. Thus, external vulnerabilities are relatively low.

INVESTMENT OUTLOOK

The shekel is underperforming after a stellar 2017. Last year, ILS rose 11% vs. USD and was behind only the best performers KRW (+12%) and MYR (11%). So far in 2018, ILS is -6% YTD vs. USD, and is ahead of only the worst performers ARS (-32%), TRY (-28%), BRL (-12%), RUB (-11%), ZAR (-8%), INR (-7%), IDR (-6%), and PHP (-6%). Our EM FX model shows the shekel to have STRONG fundamentals, and so we expect this underperformance to ebb.

USD/ILS just poked above 3.70 for the first time since March 2017. The pair was also trading at its highest level since February 2017. Charts point to a test of the January 2017 high near 3.88. Break above the 3.7560 area is needed to set up a test of the January 2016 high near 4.00.

Policymakers have relied in a weak shekel but this is likely to end under the next central bank governor. Senior economic adviser Avi Simhon recently said the weak shekel policy had outlived its usefulness. He criticized it for basically subsidizing manufacturers at the expense of the rest of the economy. If the central bank tilts more hawkish in the coming months under the new governor and the weak shekel policy is abandoned, the shekel should start to outperform.

Israeli equities are outperforming after a subpar 2017. In 2017, MSCI Israel was up 1% vs. 34% for MSCI EM and 20% for MSCI DM. So far this year, MSCI Israel is up 8% YTD and compares to -6% YTD for MSCI EM and +3% YTD for DM. With growth likely to remain robust, we expect Israeli equities to continue underperforming.

Israeli bonds have outperformed. The yield on 10-year local currency government bonds is +24 bp YTD. This is behind only the best EM performers China (-38 bp), Poland (-17 bp), Taiwan (-11 bp), Mexico (+6 bp), Korea (+9 bp), Malaysia (+11 bp), South Africa (+13 bp), and Peru (+18 bp). With inflation picking up and the central bank likely to start a tightening cycle, we think Israeli bonds will start to underperform.

S&P just upgraded Israel a notch to AA- with stable outlook. The agency noted that strong growth coupled with general adherence to fiscal rules will enable the government to lock in recent fiscal gains. It added that “The upgrade reflects improvements in Israel’s fiscal policy framework. Although public debt remains relatively high, we now think that fiscal slippages leading to a significant reversal of the debt path are unlikely.”