The response of Israel's financial markets to recent military activity has been muted to date. Over the short term, events could trigger selloffs in equities and corporate bonds, or rallies if the fighting subsides. Given current uncertainties, and mindful that investors need to avoid harming the long-term performance of their portfolios, we advise that clients refrain from making major changes in their investment allocations.
We recommend maintaining high exposure to Israeli government bonds, focusing on short to intermediate durations of up to 5 years. The rich valuation of long-dated bonds has increased the risk of holding those securities.
Expectations for subdued inflation are priced into the Israeli government bond market, due to investors getting used to the low inflationary environment and the lack of near-term catalysts that could drive inflation higher. The bond market's current pricing of inflation makes CPI-linked government bonds a preferable investment to their fixed-rate counterparts, because the odds are low of actual inflation coming in significantly lower than the inflation rate currently reflected in bond prices.
Yield spreads on Israeli corporate debt remain narrow. We advise maintaining nothing but a limited allocation to this asset class, focusing on the short-dated bonds (no more than three years out) of companies characterized by positive cash flow and mid- to high-level investment-grade ratings. In our judgment, the slight widening of spreads over the past two month is nothing but a correction in a richly valued market.
Yields on the long-dated bonds of major overseas governments, and in consequence those in Israel, are likely to trend gradually higher over the next two years, assuming the global economic recovery continues. Investors are therefore advised to avoid the government bonds of the largest developed nations—the US, Germany and Japan.
We advocate maintaining limited exposure to overseas corporate bonds, focusing on low-rated investment-grade securities with short to intermediate durations. The narrowing of spreads on speculative-grade (junk) bonds has run its course, in our view.
Equities remain our preferred risk asset. We recommend significantly overweighting overseas shares, given that Israel's economy is suffering from weak aggregate demand. In foreign equities, we advise overweighting the emerging markets, slightly overweighting European shares, and underweighting US stocks. We believe that lower valuations in emerging markets offset their inherently higher risks, especially if the level of liquidity in global markets stays high.
As with other financial assets, the shekel has been largely unaffected by the security situation, remaining little changed against the dollar this week. While upward pressures on the local currency persist, Bank of Israel policies are likely to create relative stability in the shekel-dollar exchange rate.
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