As the conflict in northern Israel intensifies, investors in the local capital market are bracing for potential shocks to the Israeli stock market. Following the escalation of hostilities over the weekend, the Tel Aviv Stock Exchange opened with notable declines, signaling rising concerns over the economic fallout of the ongoing conflict with Hezbollah. The Tel Aviv 35 index, Israel’s leading market indicator, fell by 0.1%, while the broader Tel Aviv 90 index shed 0.5% of its value in early trading.

The immediate market reaction reflects the rising uncertainty surrounding the conflict. Despite a positive performance earlier in the year, with the Tel Aviv 35 index posting gains of over 7%, the recent escalation has disrupted this upward trend. The heightened security risks are prompting investors to reassess their positions, fearing further volatility in the days to come.

In addition to stock market losses, the Israeli shekel has shown signs of weakening. On Friday, the shekel fell to around NIS 3.78 per U.S. dollar, reflecting a 2% drop over the course of the week. Analysts anticipate further declines in the currency as tensions continue to rise, with the NIS 3.80 threshold against the dollar likely to be tested in the coming days.

Economic Impact Beyond the Markets

The effects of the conflict extend beyond the stock market. The broader economic environment in northern Israel is being severely impacted by the ongoing hostilities. According to Ronan Menachem, chief market economist at Mizrahi Tefahot, the expansion of the war into previously unaffected areas represents a significant escalation. This development is not only damaging property and infrastructure but also limiting economic activity.

With schools closing and families forced to remain home, there is a notable drop in productivity and consumer spending in the region. Tourism, a key economic driver in northern Israel, is also expected to suffer, particularly with the Jewish holiday season approaching. The reduced economic activity could have long-lasting consequences for businesses in the area.

Global Implications and Risk of Intensification

The conflict with Hezbollah has broader implications for the global economy as well. Analysts warn that prolonged fighting could lead to higher global oil prices, driving inflationary pressures. This, in turn, could create more demand for the U.S. dollar as a “safe haven” currency, further weakening the shekel.

One of the most significant risks posed by the conflict is the potential for further escalation. A major intensification of the war could trigger additional financial stress, with investors fearing long-term economic damage. As Menachem points out, the current military conflict raises the possibility of a downgrade by credit rating agencies, which would increase Israel’s cost of borrowing and add pressure to the already high budget deficit.

Divergence from Global Markets

The Israeli stock market is increasingly decoupling from global markets as local risks outweigh broader economic trends. While Wall Street closed with a positive sentiment last week, buoyed by interest rate cuts, the Tel Aviv Stock Exchange remains under pressure due to the uncertain security situation. The ongoing conflict has raised Israel’s risk premium, making it more difficult for investors to find positive momentum locally.

This divergence is also evident in the bond market, where yields on Israeli government bonds have risen relative to U.S. bonds. Corporate bonds, which have so far held steady, may soon face widening spreads as investors grow more cautious about Israel’s economic stability.

Another challenge posed by the conflict is its potential impact on monetary policy. The Bank of Israel is unlikely to cut interest rates in the current environment, despite recent moves by the U.S. Federal Reserve to ease borrowing costs. The combination of high inflation and ongoing security risks will likely keep interest rates elevated, which could further weigh on economic growth.

While the situation remains fluid, some analysts are cautiously optimistic. Despite the market’s decline, there are hopes that Hezbollah may retreat from further escalation due to recent blows to its chain of command. However, until there is greater clarity on the future of the conflict, investors will likely remain on edge, with the potential for further declines in both the stock market and the shekel.

Main article photo: F-35 arrives in Israel after being purchased from Lockheed Martin (photo credit: LOCKHEED MARTIN)