The response of Israel's financial markets to the recent military activity has been muted so far. Over the short term, the ongoing 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 abstain 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.
The level of expected inflation in Israel as reflected in the local government bond market is only 1% for one year out, and 2% annually for the next five years. The prices of these securities leave little room for a significant surprise of higher inflation relative to the markets' current outlook. In consequence, we now favor CPI-linked government bonds over their fixed-rate counterparts.
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. The slight widening of spreads over the past two months in Israel's corporate bond market is nothing but a correction, in our view, 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 higher gradually over the next two to three years, assuming the global economic recovery stays on track. 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 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 remains high.
As with other financial assets, the shekel has hardly been affected by the security situation, remaining largely flat against the dollar. While upward pressures on the local currency remain, the Bank of Israel's policies are likely to deliver relative stability in the shekel-dollar exchange rate.
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