Shadow over Shekel

August 14, 2012

Israel’s financial markets had a torrid time on Monday as swirling rumours of an imminent air strike on Iran caused investors to flee. The shekel lost 1.4 percent, the Tel Aviv stock exchange fell 1.5 percent and credit default swaps, reflecting the cost of insuring exposure to a credit, surged almost 10 percent.

There has been a modest recovery today as the rumour mills wind down. But analysts reckon more weakness lies ahead for the shekel which is not far off three-year lows.  Political risks aside, the central bank has been cutting interest rates and is widely expected to take interest rates, currently at 2.25 percent, down to 1.75 percent by year-end. Societe Generale analysts are among the many recommending short shekel positions against the dollar. They say:

Expect the dovish stance of the Bank of Israel to remain well entrenched for now.

That’s not all. Investors have been pulling cash out of Israel’s financial markets for some time (Citi analysts estimate $1.6 billion fled in the first quarter of the year). After running current account surpluses for more than 8 years, Israel now has a deficit (the gap was $1.7 billion in the first three months of this year, double the previous quarter) .

Looking behind the scenes, a key factor behind shekel performance is the relative performance of Tel Aviv stocks versus the U.S. market, says Citi analyst Neil Corney.  Last year, Tel Aviv fell more than 20 percent and it hasnt recovered this year. New York’s S&P500 on the other hand has rallied 12 percent so far in 2012 and outperformed last year as well. Corney tells clients:

Local investors in Israel always have a massive home bias but have been investing abroad for a number of years now. However, whilst the local market was outperforming the U.S. markets, they generally would hedge their exposure back to shekels. The inflows into the local real money accounts are strong and growing and the recent underperformance of the local market has led us to a ….phenomena of investing abroad but without the currency hedge. The general rule of thumb that I followed was at least one quarter of underperformance would cause local real money to increase their offshore investments and increase their short shekel position.

Quite simply, these outbound investors are betting the shekel will at best not strengthen much  in the short-term, so it makes sense for them to stay unhedged.

The last time we saw these unhedged outflows was in 2002, the year the shekel/dollar exchange rate slumped to 5  from 4.25 in the space of six months, Corney says.  And as he points out, that was also the last time Israel ran a current account deficit.

 

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