Investor sentiment towards Israel can be tricky to decipher, with contrasting indicators painting an ambiguous picture. On the one hand, certain data points suggest significant concerns among investors, while on the other hand, indicators such as the dollar-shekel exchange rate and the stock market imply relative stability. All of this is happening amidst an increasingly volatile security situation. So, what factors do investors need to consider when looking at investment opportunities in the Israeli stock market?

Rising Risk Premium on Government Bonds

The most notable concern comes from Israel’s ten-year government bond credit default swap (CDS) spreads. The CDS spread, a measure reflecting the cost of insuring against a country’s default, has surged to over 180 basis points. This is higher than the levels seen at the start of the war and represents a 12-year high, signalling investor anxiety about Israel’s ability to meet its debt obligations.

Furthermore, when looking at the ten-year bond spreads relative to U.S. Treasury bonds, which are considered risk-free, the picture remains troubling. With U.S. bonds offering yields of around 3.8%, Israeli bonds have added nearly 2% on top of that, suggesting higher perceived risk. These spreads resemble those of emerging markets like Mexico, highlighting investors’ caution.

Local Bond Market

The local bond market also reflects this unease. The yield on Israel’s ten-year shekel bond recently crossed the 5% mark, a two-month high, signalling that investors demand higher returns in exchange for greater risk. Unlike equities, which can fluctuate for various reasons, government bonds are more closely tied to the fundamentals of a country’s economy. The Tel Gov-Shekel 10+ index, which tracks government bonds with the longest maturities, is trading at an implied yield of 5.32%. Such high yields suggest that bond investors are factoring in significant uncertainty regarding Israel’s economic stability.

Shekel’s Resilience Amid War and Market Volatility

In contrast to these concerning bond market signals, the dollar-shekel exchange rate has remained relatively stable. On the eve of the war, the exchange rate stood at 3.86 shekels per dollar, but today it is around 3.75. Many market analysts expected a sharp devaluation of the shekel amid escalating tensions, potentially pushing the rate past 4.0 shekels per dollar. Surprisingly, despite fluctuations, the shekel has not depreciated dramatically, nor have its movements been as volatile as during the initial days of the war or the political turmoil surrounding judicial reforms last year.

Several factors explain the shekel’s unexpected stability. First, the Bank of Israel played a decisive role by announcing a plan to sell up to $30 billion from its reserves to stabilize the currency. In the initial weeks of the war, the central bank sold approximately $8.5 billion, helping buoy the shekel. Just the knowledge that the Bank of Israel holds significant foreign reserves offers additional reassurance to the market.

Another factor is the relationship between Wall Street and the shekel. Historically, when U.S. stock markets perform well, the shekel tends to strengthen due to hedging activities by Israeli institutions. While geopolitical risks may have weakened this correlation, it remains influential. Strong U.S. market performance this year has thus contributed to the shekel’s resilience.

Finally, the role of foreign investors must be considered. Often the first to exit in times of crisis, many international investors left the Israeli market when the war began. However, those who remain may have become accustomed to the heightened risks Israel faces, creating a level of acceptance that stabilizes the shekel.

Optimism Amid Crisis?

Recent successes in Gaza and Southern Lebanon have helped alleviate fears of a worst-case scenario, fostering a cautiously optimistic market sentiment. This optimism has translated into a series of gains in the local stock market. Additionally, the strong performance on Wall Street and the Federal Reserve’s interest rate cuts have provided further momentum, giving Israel’s stock market an additional boost.

However, this optimism remains fragile. Experts warn that a broader war, with more extensive damage to civilian infrastructure, could have far more severe consequences for both the stock market and the shekel. Therefore, investors remain cautious, knowing that any escalation in hostilities could quickly erode the stability that currently seems tenuous.

Overall, while rising government bond yields and CDS spreads underscore growing risks for investors in Israel, other factors – such as the resilient dollar-shekel exchange rate and gains in the stock market – reveal a more nuanced reality. The Bank of Israel’s interventions, the strength of U.S. markets, and changes in foreign investor behaviour are all pivotal in shaping this complex landscape. However, Israel’s economic outlook remains highly uncertain, as any further escalation in the security situation could swiftly undermine the current stability, potentially leading to a more severe downturn.

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