Israeli Political Risks Heating Up

new israelPolitical risk in Israel is picking as pressure builds on Prime Minister Netanyahu.  Until the uncertainty clears, we believe Israeli assets will continue to underperform.

POLITICAL OUTLOOK

Police recommended that Prime Minister Netanyahu be charged with bribery, fraud, and breach of trust.  Prosecutors along with Attorney General Mandelblit will now examine the evidence collected by the police and then decide whether to indict the Prime Minister.  Mandelblit was once Netanyahu’s cabinet secretary and was appointed Attorney General by him two years ago.

Netanyahu has denied all wrongdoing and vowed to continue leading the country.  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.

Due to the nature of Israeli party politics, coalitions are typically made up of many small parties and are thus inherently unstable.  No government has lasted a full four-year term since 1984-1988.  For now, Netanyahu’s allies are circling the wagons.  Center-right Kulanu party said will not leave the coalition and is awaiting the decision from the Attorney-General.

General elections aren’t due until November 2019, but a collapse in the government would bring that forward.  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.

Recent polls show that several opposition centrist and center-left parties are gaining in popularity.  These include including Yesh Atid, led by Yair Lapid, and the Zionist Union, led by Avi Gabbay.  The last poll was conducted February 1, before this latest news on Netanyahu.  According to that poll, the opposition bloc still does not appear likely to win enough seats to form a majority.

The Palestinian issue is likely to flare up.  US President Trump has made the controversial decision to recognize Jerusalem as Israel’s capital.  He committed to relocating the US embassy there by end-2019.  In related news, there have been recent press reports that the US and Israel are discussing outright annexation of West Bank territory, a move that would effectively kill the two-state solution.  On the other hand, if a center-left government were to take power, Israeli-Palestinian relations could improve.

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 even better in Transparency International’s Corruption Perceptions Index (28 out of 176).

ECONOMIC OUTLOOK

The economy remains robust.  GDP growth is forecast by the IMF at 3.4% in 2018 after an estimated 3.3% in 2017.  GDP rose 3.5% SAAR in Q3, the strongest rate last year.  Monthly data in Q4 suggest some acceleration and highlights upside risks to the growth forecasts.

Price pressures remain low, with CPI rising only 0.4% y/y in December.  While deflation has ended, inflation is well below the 1-3% target range.  January CPI will be reported Thursday and is expected to ease to 0.2% y/y.  A strong shekel has helped limit inflation, but this may be reversed in light of recent currency weakness.

The central bank has been on hold since February 2016, when it cut rates 15 bp to 0.10%.  Despite deflationary risks, the bar to further action is very high.  Next policy meeting is February 26, and no change is expected.  For now, the bank is likely to continue using a weaker shekel (via jawboning and FX intervention) as the main lever of stimulus.  Markets are pricing in risks of the first rate hike in Q4, but we think it will be a 2019 story.

The fiscal outlook is likely to worsen.  The government has relied on increased spending to shore up popular support, and that will likely increase if Netanyahu faces greater political risk ahead.  The budget deficit came in at around -2% of GDP in both 2016 and 2017, but the OECD forecasts it to widen to nearly -3% in 2018.

The external accounts should remain in good shape.  The current account surplus was an estimated 4.1% of GDP in 2017, and is expected by the IMF to narrow to around 3% in 2018.  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 have risen to record highs as FX intervention continues.  At $117.6 bln in January, reserves cover nearly 13 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 has underperformed after outperforming in 2017.  In 2017, ILS rose 11% vs. USD and was behind only the best performer KRW (+13%).  So far in 2018, ILS is -1.5% YTD and is ahead of only the worst performers ARS (-7%) and PHP (-4%).

Our EM FX model shows the shekel to have STRONG fundamentals, and so it should start to outperform more.  USD/ILS is making new highs for this year and is threatening the 3.55 area.  A break above that would target the August high near 3.6370.  Using the January 2017 to January 2018 move lower, the major retracement objectives are 3.57 (38%), 3.6290 (50%), and 3.6880 (62%).

Israeli equities continue to underperform.  In 2017, MSCI Israel was up 0.5% vs.  34% for MSCI EM and 20% for MSCI DM.  So far this year, MSCI Israel is -2% YTD and compares to +3% YTD for MSCI EM and -1.5% for MSCI DM.  While the economic fundamentals are good, we think Israel equities will continue to underperform as long as political uncertainty is hanging over the nation.

Israeli bonds have underperformed recently.  The yield on 10-year local currency government bonds is +26 bp YTD.  This is behind only the worst YTD performers Turkey (+49 bp), Hungary (+47 bp), and Korea (+29 bp).  With inflation likely to remain low in H1 and the central bank remaining in dovish mode into 2019, we think Israeli bonds could start to outperform more.

Our own sovereign ratings model showed Israel’s implied rating falling a notch to A+/A1/A+, putting it right at actual ratings.  Last year, we saw some upgrade potential but that no longer holds.