Israeli Fundamentals Are Strong But Political Risk Is Rising

Israeli flag background. Vector illustration

Israeli Prime Minister Netanyahu is being investigated for corruption even as his government was censured by the UN over the controversial West Bank settlements. While the economy remains robust, rising political risk (both domestic and regional) may keep investors wary.

POLITICAL OUTLOOK

The Justice Ministry said investigators questioned Prime Minister Netanyahu for three hours Monday “under caution.” This means that anything said could be used in court if Netanyahu is eventually charged with a criminal offense. Press reports that Netanyahu is being investigated on suspicion that he received illicit gifts and favors from business executives. Some report that he is also being investigated for another matter but no details were given.

Attorney General Mandelblit ordered a probe back in June after police received information regarding Netanyahu’s activities. The investigation led to testimony from dozens of witnesses both inside and outside of Israel. Officials said that the investigation has expanded beyond its initial scope, but no further details were given. Netanyahu has denied any wrongdoing.

For now, we assume that Netanyahu remains in power. The opposition remains weak, while the Likud-led coalition shows little signs of in-fighting. Netanyahu enjoys strong popular support, and no credible challengers have emerged yet. The next elections are due by 2019, but we note that no administration has completed a full four-year term since the 1984-88 “unity” government.

The recent UN Security Council resolution condemning the continue building of settlements is non-binding and will have no immediate impact on Israel. Indeed, relations with the US are likely to improve under the incoming Trump administration. President-elect Trump’s pick for US ambassador to Israel is New York bankruptcy lawyer David Friedman, who in the past has supported complete annexation of the West Bank.

Yet domestic political tensions could rise if Israel believes it has carte blanche to intensify building the controversial settlements on the West Bank. Israeli-Palestinian violence has been sporadic and limited in recent months, but could pick up if the political climate worsens. PLO Secretary-General Erekat called on Netanyahu to meet with Palestinian Authority President Abbas in Paris, where France is sponsoring a peace conference on January 15.

ECONOMIC OUTLOOK

The economy remains robust. GDP growth is forecast at 3.2% in both 2017 and 2018. GDP rose 5.1% y/y in Q3, pointing to upside risks to the growth forecasts. Indeed, the Bank of Israel just raised its 2016 growth forecast from 2.8% to 3.5%.

Price pressures remain weak, with CPI falling -0.3% y/y in both October and November. Still, this is the “highest” (least negative) rate since February. Higher energy costs and low base effects should see inflation move higher this year. The central bank’s monthly survey shows inflation is expected at 0.6% in 12 months from now.

The central bank has been on hold since its last 15 bp cut to 0.10% back in February 2015. With the economy fairly robust, we see no need to ease further via unconventional measures. Indeed, we see risks that the bank will have to tilt more hawkish this year if inflation rises more than anticipated.

Fiscal policy bears watching. The Likud government has promised increased spending in a variety of areas in order to keep support from its various coalition partners. The budget deficit is estimated at -2.5% of GDP in 2016. It is expected to widen slightly to almost -3% this year, but we see some upside risks.

The external accounts are in good shape. The strong shekel has weighed on exports even as the strong economy has boosted import demand. However, the current account surplus is estimated at 4.2% of GDP in 2016, and is expected at 4.3% in 2017. Foreign reserves have fallen modestly, but at $97.1 bln in November, they cover nearly 12 months of import and are over 3 times larger than short-term external debt.

INVESTMENT OUTLOOK

The shekel has generally outperformed in EM. In 2015, ILS was basically flat vs. USD. This was the best in EM and compares to the worst performers ARS (-35%), BRL (-33%), ZAR (-25%), COP (-25%), and RUB (-20%). In 2016, ILS was -1% vs. USD and was closer to the middle of the EM pack. Our EM FX model shows the shekel to have VERY STRONG fundamentals, so last year’s “so so” performance is likely to improve in 2017.

A weaker shekel remains the main lever of stimulus for policymakers. The central bank will continue to intervene as needed to prevent excessive currency strength this year. The bank also plans to buy $1.5 bln in 2017 just to offset the FX impact of increased natural gas production and export. A break of 3.89 is needed to set up a test of the 2016 high for USD/ILS near 3.99.

Israeli equities have underperformed in 2016 after a strong 2015. In 2015, MSCI Israel was up 9.4% while MSCI EM fell-16.6%. In 2016, MSCI Israel was -27% and compares to +7% for MSCI EM. This underperformance should ebb in 2017, as our EM Equity model has Israel at a VERY OVERWEIGHT position.

Israeli bonds performed well last year. The yield on 10-year local currency government bonds was about -19 bp in 2016. This was behind the best performers Brazil (-503 bp) and Colombia (-155 bp) but ahead of the worst performers Mexico (+119 bp) and the Philippines (+104 bp). With inflation likely to rise and the central bank’s next likely move to be a hike, we think Israeli bonds will start underperforming more.

Our own sovereign ratings model shows Israel to have an implied rating of AA-/Aa3/AA-. This compares to actual ratings of A+/A1/A+ and so we see some growing upgrade potential from all three agencies. Israel is just on the cusp of the higher rating, however, and so the agencies are unlikely to be in a rush to upgrade. Indeed, Fitch just upgraded Israel to A+ with a stable outlook in November.