Israeli Shekel detached from fundamentals

Summary

The Israeli shekel has faced uncharacteristic depreciation pressure over the last few weeks in response to escalating political risk tied to Benjamin Netanyahu's judicial reform proposals. So much so that we believe the Israeli shekel is oversold and is no longer aligned with the underlying fundamentals of Israel's economy. Even with newly elevated political risk, Israel maintains some of the strongest fundamentals in the emerging markets, and our FX vulnerability framework suggests the shekel may be poised for a strong rebound by the end of Q1-2023. In addition, we believe the likelihood of BOI intervention to support the shekel is rising, which can exacerbate the currency's recovery.

Judicial reform and political risk is hurting Israeli Shekel

We have not said this too often. But, the Israeli shekel is underperforming relative to the rest of the emerging market currency complex. Strange message to communicate. Typically, the emerging market currencies that underperform are found in Turkey or Argentina. However, the shekel's recent weakness is noteworthy and understandable. For context, the Likud party won the 2022 legislative election. In Israel, the winning party's representatives nominate and recommend a leader in the Knesset (Israel's Congress). Late last year, following the Likud victory, Benjamin Netanyahu was recommended and eventually appointed by Israel's President to lead the nation's policy agenda. Netanyahu was then able to secure a governing coalition in the required timeframe and received a vote of confidence in the Knesset to formally become Prime Minister. While he is no stranger to political office, Netanyahu's policy proposals are generating local political risk and acting as the primary driver of the shekel's underperformance. The proposals that have shaken local financial markets are centered around reforming the country's judicial system, specifically the Supreme Court of Israel. At a high level, Netanyahu and his alliance parties have proposed, and advanced through early stages of parliamentary approval, a law that would allow the governing coalition to override any Supreme Court ruling with a simple majority vote, which the Netanyahu alliance has. Should this law be passed, the ability of the Supreme Court to strike down legislation would be severely limited. In addition, the proposal gives the government an increased ability to select Supreme Court judges.

These proposals have been met with nationwide protests that have not only disrupted economic activity, but more importantly contribute to local political risk that is rising to concerning levels. While we will refrain from commenting on whether judicial reform was needed or not, we can say that Israel's governmental checks and balances system, as well as the country's democracy, could be at risk should these proposals be implemented. In our view, a lack of a prudent checks and balances system as well as a diminished democratic framework elevates political risk in Israel to the point where local politics is now, and could be in the future, a source of stress on the Israeli shekel. Historically, Israel has experienced political turnover quite frequently, although the shekel has very rarely responded to political developments, and we usually have not classified political risk as concerning. However, we now believe political dynamics have changed for the worse, and the shekel can be more sensitive to policy implementation, particularly policy directed toward the Supreme Court, going forward.

But, Israel's fundamentals are strong

As concerning as the latest political developments are, Israel's underlying fundamentals are some of the strongest across the emerging markets and can act as foundation for a near-term shekel recovery. Israel maintains a solid investment grade sovereign credit rating by both Moody's (A1) and S&P (AA-). Relative to other credit in the Europe, Middle East and Africa (EMEA) region such as Poland, Hungary, South Africa and Turkey, Israel's fundamentals are the strongest. In fact, relative to other large emerging markets across all regions, S&P rates Israel's creditworthiness the strongest (Figure 1), while Moody's rates Israel quite strongly and has a “positive outlook”, indicating a rating upgrade could be imminent. While local politics now represent a downside risk to the rating, a downgrade out of investment grade territory or toward the lower end of the investment grade spectrum is unlikely. It is these sound fundamentals that historically has led to subdued Israeli shekel depreciation, even during periods of extreme stress in global financial markets. To that point, during the COVID-induced selloff in early 2020, the shekel depreciated a little over 10.5% against the U.S. dollar. Regional EMEA currencies experienced more sizable depreciations during the COVID downturn. Other periods of global market stress—such as the Fed's multiple shifts toward tighter monetary policy over the course of last year—also resulted in relatively limited shekel depreciation of 10% or less (Figure 2). The recent bout of shekel depreciation has not been in the context of a global selloff, but rather local developments driving currency weakness. Without a backdrop of a global market shock, we believe the shekel may be oversold relative to underlying fundamentals.

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