We expect yields on the bonds of major overseas governments to climb incrementally over the medium term, assuming the global economic recovery continues, particularly in the US. Accordingly, investors are advised to avoid the government bonds of the largest developed nations—America, Germany and Japan.
Equities remain our preferred risk asset, and we recommend significantly overweighting overseas shares, given that Israel's economy is experiencing weak aggregate demand. In foreign equities, we recommend overweighting the emerging markets. In contrast, we advise underweighting Japan. We're downgrading Europe from overweight to market-weight, and upgrading US shares from slightly underweight to market-weight in light of the anticipated growth divergence between America and Europe, stemming from the Continent's economic slowdown.
In US equities, we favor sectors likely to prove less vulnerable to rising interest rates—high-tech, financials, and energy. We recommend avoiding the real estate sector and companies sporting very high dividend yields, since both are likely to be particularly vulnerable to rising interest rates.
We advocate maintaining limited exposure to overseas corporate bonds, focusing on low-rated investment-grade debt with intermediate durations. We recommend avoiding speculative-grade bonds, whose spreads are still too narrow for their inherent risk.
We recommend maintaining high exposure to Israeli government bonds, focusing on five-year durations. After the Bank of Israel lowered its key interest rate to 0.25%, near-zero yields on short-dated bonds now render this segment of the market an undesirable investment. At the long end of the curve, rich valuations have increased the risk of holding those maturities.
Yield spreads on Israeli corporate bonds remain narrow. In consequence, we advise maintaining nothing but a limited allocation to this asset class, focusing on the short- to medium-dated bonds of companies characterized by positive cash flow and mid- to high-level investment-grade ratings.
While the short-term impact of recent hostilities on Israel's economy was limited, the combination of sluggish economic growth, which preceded the strife and the hostilities' potential third-quarter impact on the local economy, has increased financial-market risks. In consequence, we recommend maintaining nothing but relatively low exposure to Israeli stocks and corporate bonds.
The shekel's decline against the dollar in recent weeks is a product of the greenback's strength across the globe as well as developments in Israel. Part of the shekel's weakness is attributable to the diverging pace of projected economic growth in the US and Israel in the second half of 2014. Accordingly, there's now less reason to establish foreign currency hedges on investors' overseas security holdings.
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