The Cutting Edge Outlook: Israel’s Economic Prospects

As the possibility of a longer ceasefire in Gaza hangs in the balance, market attention has started to turn to another aspect of the Israeli conflict. Namely, the outlook of the Israeli economy. It should be noted that the issue was highlighted by two events, specifically the release of Israel’s preliminary GDP rate for Q4 of 2023, where a wide contraction was noted and the downgrading of Israeli bonds by Moody’s, a downgrading that was fiercely fought by the Netanyahu government. In this report, we intend to dwell deeper into the prospects of the Israeli economy in the short-term.

The Political Scene

Definitely the first element that has to be mentioned is that at the current stage Israel is at war, a characteristic that drives the economy but also politics in Israel. Yet the “rally around the flag” effect seems to be artificial on a political level. It should be noted that before the attacks Netanyahu was leading a right, to extreme right-wing government, yet after the attack an emergency unity government was formed, by also including the main opposition party National Unity.

Nevertheless, extreme right-wing elements are still included among its members and overall the government does not seem to have lost its ultra-nationalist orientation. Despite Netanyahu being the Prime Minister of a temporary unified coalition now, his approval ratings seem to be falling fast and hard. Hence, we would dare to say that his political outlook remains uncertain at best. It should be noted that in a deeply divided Israeli society, even before the Hamas attack, Netanyahu’s ratings were especially low.

Hence, we tend to expect a certain degree of uncertainty for the outlook of Israel’s political scene, an uncertainty that could also be overspilled to the economy. It was suggested that the next legislative elections for the 26^th Knesset may be set early next year a scenario that may create friction in the Israeli political scene and inside the government itself, yet that remains to be seen.

The Macroeconomics

On a macroeconomic level, inflation has been slowing over the past year, after a slight jump in August, and for January seems to have landed at 2.60% yoy. It should be noted that it’s the first time that the inflation rate is within Bank of Israel’s (BoI) target of 2.00%±1.00% since January2022, a development that tends to be considered as a positive for the economic outlook. At the same time, we also note that Israel’s trade deficit narrowed to -1.4 billion USD, a level that was not seen before, since the 2020 pandemic, which could be regarded as another positive signal.

Yet, all of that is overshadowed by the wide contraction of the GDP rate as shown by the preliminary release of -19.4% quarter on quarter for Q4 2023. It should be noted that some contraction was expected due to the ongoing war, yet estimates by analysts tended to be around a rate of -10% qoq. It’s more than obvious that the situation is way worse than initially expected, darkening Israel’s economic prospects.

Monetary Policy and the Shekel

On a monetary policy level, we note that BoI despite cutting rates by 25 basis points in November, it tends to maintain a relatively high interest rate at the level of 4.50%. In its latest interest rate decision, the bank highlights understandably, the wide uncertainty surrounding the Israeli economy, and notes that “The interest rate path will be determined in accordance with the continued convergence of inflation to its target, continued stability in the financial markets, economic activity, and fiscal policy”.

Yet we tend to expect an easing of the relatively tight monetary policy, given that inflation has returned within the bank’s target range and seems to have a tendency to ease further. At the same time, the wide contraction of the GDP rate in Q4 2023 is adding pressure on the bank to start cutting rates earlier and at a faster pace, in order to rejuvenate the ailing economy.

It should be noted though, that the bank seems to have successfully defended the Shekel (ILS), as despite a considerable weakening of the Israeli currency until the end of 2023, the ILS’s drop was not allowed to come to extreme levels. On the contrary, it was controlled and moderated. Overall though, we expect that a possible easing of the bank’s monetary policy could have an adverse effect on the ILS, as could a prolonged war. Yet, once again the bank seems to have enough FX reserves to defend its currency, as seen in the past few months and its characteristic that the FX reserves have risen in January, which are at relatively high levels.

The Outlook

So what’s the way forward? The downgrading of Israel’s bonds by Moody’s was characteristic of the predisposition of the markets for the outlook of the Israeli economy. The downgrade (from A1 to A2) was practically a double whammy, as despite Israeli bonds still being at an investing grade, the credit rating agency added a negative outlook, which practically opens the door for another downgrading.

More credit rating agencies are expected to follow and despite the rise of interest rates being tolerable for any additional loans Israel may undertake, the drag on the economy will widen. As long as the war is ongoing, uncertainty is bound to remain high and the probability of an adverse effect on the economy rises considerably. We are citing three specific issues that the Israeli economy may have to face in such a scenario.

The first would be that Israel’s attractiveness, as an investing destination, could be tarnished substantially, which in turn may weigh on the current account balance. To this issue we have to note that Intel’s $25 billion chip factory plans seem to go ahead albeit a relative hesitancy on behalf of the chipmaker and a stalling. Yet the plans got a green light temporarily, only after the Israeli government contributed $3.2 billion.

Second, the Israeli Government will have to keep its military reserves deployed, which would mean that a part of its workforce will not be able to contribute to the country’s economy at least not from their workstations. In addition to that the government will have to pay all these reserves increasing its expenditure. Last but not least, we would note that the direction of fiscal spending will be bound towards the war effort primarily, which could prove costly and may force the Netanyahu government to borrow more and more funds, a scenario that is expected to have a longer-term adverse effect on future fiscal policy, as the loans will have to be repaid at some point.

All of that is under the idea that there will be, no second front, say for example near the border with Lebanon, while all other factors are to remain unchanged, say continuous support from the US primarily and any other allies. Yet with Trump’s possible re-election, the US support seems to be hanging in limbo, given the former US President’s unpredictability.

Also, should Israel win the war, or should there be some sort of settlement either in the form of a permanent ceasefire or a political solution, a scenario that does not seem to be on the horizon currently, we also expect that a more moderate government will be required for Israel in order to reunite the Israeli nation and regain Israel’s credibility in the international political stage.

Disclaimer: This information is for educational purpose only and should not be considered as an investment advice or investment recommendation.