24 May 2023
Over recent months, controversial proposals by Israel’s government (elected in late 2022) sent shockwaves through the country and financial markets. Proposed changes to the judiciary sought to increase the control of politicians over justice-sector appointments and limit the power of the Supreme Court to overturn government decisions and laws. This prompted large-scale protests, drove bouts of volatility across domestic asset prices, and sparked outflows.
Meetings with policymakers, diplomats, analysts and independent experts in Jerusalem and Tel Aviv gave me comfort that the current proposals are unlikely to go ahead, given the extent of population unease and the sense that the government will seek to minimise the political fall-out. That’s my base case expectation and it has positive implications for fixed income assets over the short-to-medium term.
However, the broader implications of this whole episode are substantial. It has revealed a key governance vulnerability relating to a lack of checks and balances on the powers of Israel’s executive branch – this prompted both our downgrade to the country’s governance score within our proprietary ESG framework in January and Moody’s revision of its outlook to stable from positive in April. The ill-conceived proposals also highlighted how Israel’s lack of a written constitution means people feel their rights are not protected, with the widespread protests bringing this into stark relief. When the State of Israel was founded, this issue was intentionally left for future generations to consider when the time was right – that time seems to have arrived.
Israel’s economy is still performing exceptionally well. During my trip I discovered a vibrant, growing, innovative, and confident economy. Here, the proportion of spending on Research and Development is the highest in the world at 5.6% of GDP in 2021, compared with 3.5% in the US, according to OECD data. Further evidence of Israel’s fundamental strength can be found in the IMF’s concluding statement following a recent official staff visit, which describes the country’s economic performance as “remarkable”, with the growth rate rising to 6.5% in 2022. Public debt-GDP fell from 68% in 2021 to just under 61% last year and the country’s current account is in surplus.
Since the controversial proposals were first tabled, Israeli assets have sold off significantly and indiscriminately. Relative-value analysis shows that some of those assets - the shekel, hard currency debt as well as domestic market equities - still embed a significant idiosyncratic risk premium. We expect these relative premia to be unwound should our base case materialise and the government pass a watered-down version of current proposals (leaving out the most controversial elements) – that could provide a significant boost to asset prices. The outlook for the shekel is also supported by Israel’s credible central bank, which remains committed to tackling sticky inflation.
While Israel’s economy is strong today, the country faces major questions around the long-term sustainability of its economic structure and social fabric. This is an economy of stark contrasts: on one hand, it has a world-leading, fast-growing technology sector; on the other, its labour-market participation rate is relatively low, with demographic trends likely to exacerbate this and result in a shortage of skilled labour in future years. This latter point is a key consideration for new start-ups and tech companies as they assess the relative attractiveness of Israel within their investment decisions.
While these concerns are not new, the backlash to the recent proposals appear to have awoken this sleeping giant. The schism in Israel’s economy was a topic of conversation in almost all of my meetings. Crucially, though, the tone was overwhelmingly constructive – this is a nation that knows it has challenges to address but is ready for open conversations around the future shape of the economy and society. How this all unfolds will be crucial for long-term investors. However, the level and energy of engagement on this topic gives me cause for optimism.