The continuing conflict between Israel and Hamas in the Gaza Strip and the complicated situation on Israel’s northern border mean that the Israeli economy faces considerable uncertainty, which finds expression in several metrics. For example, the direct confrontation between Israel and Iran contributed to the weakening of the shekel and brought the risk premium on government bonds (CDS) to a more than ten-year peak. By contrast, during the Passover holiday that ended on Monday, when talk of a deal with Hamas for a ceasefire and the release of Israeli hostages became prevalent, the shekel strengthened sharply, and the Tel Aviv Stock Exchange, which resumed activity yesterday, was boosted by the reports of a deal, and the main indices rose.
With the help of three senior analysts, we attempted to sketch what might happen to the local economy in each of the following scenarios: the signing of a ceasefire agreement and a prisoner exchange; further escalation including extensive Israeli military operations in the Gaza Strip; and things continuing as they are, with no significant escalation in the conflict, but no ceasefire agreement either.
1. A deal could boost the shekel
One of the main and quickest-reacting barometers of sentiment towards the local economy is the shekel-dollar exchange rate. Despite the sharp appreciation of the shekel in the past few days, as talk of a deal with Hamas swirled, the shekel-dollar rate still prices in a high risk premium. So far this year, the shekel has depreciated by 4% against the dollar.
Before 2023, the shekel was one of the strongest currencies in the world, but last year, even before war broke out, it depreciated as a result of the government’s judicial overhaul plan and the fierce reaction to it.
According to various estimates, the shekel-dollar exchange rate prices in a risk premium of about NIS 0.30. Evidence of that can be found in the forecast released a few days ago by Bank of America, which expects that the shekel will strengthen gradually in the coming quarters and that the shekel-dollar rate will reach NIS 3.5/$ by early next year, assuming that the uncertainty that prevails in Israel reduces. The current rate is around NIS 3.73/$.
Modi Shafrir, chief financial markets strategist at Bank Hapoalim, says, "Until the end of last week, the markets did not price in a high probability of a situation in which a ceasefire begins and a hostage deal is formulated between Israel and Hamas, and so the shekel continued to weaken against the basket of currencies and Israel’s risk premium rose." Shafrir points out that the main factor weighing on the performance of Israeli markets recently has been the escalation vis-à-vis Iran, which raised fears of a regional conflict. In the past two weeks, that fear moderated somewhat, as the markets came to realize that there would not be a renewed flare-up with Iran, but at the same time did not expect a deal.
"An agreement for the release of hostages could put progress on normalization of relations between Israel and Saudi Arabia back on the table, as US Secretary of State Blinken shuttles around the Middle East. That would lead to a corresponding fall in Israel’s risk premium, and to a strengthening of the shekel," says Shafrir.
On the other hand, he says, if negotiations on a hostage release deal break down, that could put the shekel back on the depreciating trend we have seen up to now, while the risk premium will rise. The big question is, by how much? Shafrir says that these trends will not be too strong, since the shekel-dollar rate and the risk premium are in any case high. In addition, he says that any assessment is difficult because "the effect of going into Rafah will depend on what the headlines are around the world, and on the operation itself."
Mizrahi Tefahot Bank chief strategist Yonie Fanning explains that the global foreign exchange market manifested very high pressures in April, and that this was not just a local phenomenon. "It was something across markets around the world. We saw it in the risk premium in the oil market as well, and in the strengthening of the dollar against the basket of currencies, because of global tensions. The fear of all-out conflict between Israel and Iran was very high," Fanning says. In his view, if there is a deal between Israel and Hamas, this will cause the shekel to strengthen considerably. He sees a rate of NIS 3.65/$ as a definite possibility if we see a deal coming together.
2. The stock market will not calm down quickly
Last year, and this year to date, the local stock market underperformed in relation to leading world markets. So far this year, the Tel Aviv 35 Index has risen by about 3%, while the return on the S&P 500 is almost double that. How will a ceasefire affect the stock market?
Leader Capital Markets chief economist Jonathan Katz says, "The strength of the rise will be a function of the agreement and what it looks like, whether it’s permanent and sustainable or not." He says that a scenario of the return of the hostages and a long-term ceasefire will lead to understandings and a calming of the situation in the north as well. "A ceasefire in the south will avert the need to go into Lebanon and open another front. If the markets understand that, then this will be a positive scenario," he says, adding that the rise in the markets will be a cross the board and will take place in the stock market together with appreciation of the shekel and a decline in Israel’s risk premium.
Katz says that Israeli stocks have taken a double blow. "The social unrest and the judicial reform program in early 2023 led to a negative horizon for the markets and to negative outlooks on the part of the rating agencies, even before the war. To that was added the geo-political tension since last October. It does not seem to me that we will make up the gap, because it stems from further factors that won’t necessarily disappear."
Bank Hapoalim’s Shafrir, on the other hand, estimates that we won’t see sharp movement either way. "The stock market will be affected by geo-political events, because it tends to be sensitive to them," he says. "Nevertheless, the stock market in Israel has been underperforming since the beginning of 2023, so it’s not certain that we’ll see a strong impact on the markets, given the high degree of nervousness that already prevails."
Fanning too does not see the stock market surging any time soon. "In general, the stock market goes together with the foreign exchange market. But the risk premium is still high, and so investors will not hurry back to the Tel Aviv Stock Exchange."
3. Escalation will deepen the fiscal deficit
According to estimates by the Ministry of Finance and the Bank of Israel, Israel’s fiscal deficit for 2024 will be 6.6% of GDP. On the financial markets, however, there are much more pessimistic forecasts, of a deficit of as much as 8% in the current situation. Both international bodies and the Bank of Israel say that severe escalation in the security situation, such as all-out war in the north, will wreck the forecasts.
"We have received a large aid package from the US ($26.4 billion), and that will help Israel’s fiscal position," says Shafrir, who stresses that the aid is important. Nevertheless, "significant escalation could send Israel’s risk premium, and its fiscal deficit, higher."
Katz, who in the distant past worked in the Ministry of Finance Budgets Division, explains that the deficit is affected by three unknowns. The first is the US aid, which was held up in the corridors of the US Capitol, but which Congress recently approved.
"The second unknown is the opening of a northern front and escalation. Such an event is not budgeted for, and could lead to government expenditure rising sharply. A ceasefire will remove that threat, and will of course be positive for the deficit." says Katz.
The third layer is the potential for an economic rebound after the war. So far, Katz says, Israel’s economy has stood up well, and further strengthening could lead to higher tax collection and a narrowing of the deficit from the revenue side.
Published by Globes, Israel business news - en.globes.co.il - on May 1, 2024.
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