Israeli Markets React to Election Uncertainty, Bond Market Faces Key Risk

Following the closure of polling stations and vote counting, investors in the Tel Aviv Stock Exchange are concerned about who will manage Israel's economy post-election. Sharp declines were recorded on Wednesday, with the TA-35 index dropping 1.81%, the TA-90 index falling 4.47%, and the construction index plummeting 8.77%. These drops reflect fears of prolonged political stalemate. However, the more significant economic concern lies in the bond market, which may determine the cost to the Israeli economy of the electoral uncertainty. The capital market does not necessarily require a specific political bloc to win; rather, it prioritizes the formation of a stable government, budget approval, and clear economic policy. In their absence, investors must price in not only the current economic situation but also the risk of delayed essential budgetary decisions. Even if the Bank of Israel lowers interest rates, this does not guarantee a corresponding decrease in long-term financing costs for the state and businesses. The interest rate set by the Bank of Israel and the yield demanded by investors on long-term government bonds are distinct. The former is influenced by economic activity and inflation, while the latter incorporates expectations about the economy's economic vector, debt issuance volume, and the country's risk premium. On Wednesday, the yield on ten-year Israeli government bonds rose to approximately 4.12%. If the political stalemate continues and increases fears of a widening deficit, investors may demand higher compensation for holding long-term government debt, even if interest rates are lowered.

The fiscal starting point is challenging. A Bank of Israel forecast from October 21 estimated the deficit for 2027 at 4.6% of GDP, assuming a continuing budget and highlighting uncertainty around defense spending. A continuing budget limits the government's ability to set new priorities. The longer the stalemate persists, the harder it may be to formulate a credible fiscal plan to address defense spending and financing needs, potentially turning a political crisis into an economic problem. Foreign investors do not need to flee for the stock market to be affected; their continued waiting is sufficient. Some have already reduced exposure to Israel during periods of security and legal uncertainty and may now prefer other markets until the political picture clarifies. Conversely, a widespread capital flight is not necessarily expected, as local institutional investors provide a significant demand for Israeli assets and can moderate volatility. For investment management, caution is advised in the bond market. Extending the duration of unlinked shekel government bonds is currently not justified, with a preference for short to medium durations (three to four years), favoring index-linked bonds for protection against renewed inflationary pressures. However, even linked bonds are exposed to capital losses if yields rise. High selectivity is required in corporate bonds, especially for companies needing to refinance significant debt soon.

In the stock market, a distinction is emerging between companies dependent on the local economy and those operating primarily in global markets. Wednesday's trading saw companies like Tower, Nova, and Camtek rise despite the general market decline, as they are influenced by global investment cycles and AI infrastructure rather than domestic demand. The weakening shekel may also support their profitability. Defense exporters with substantial foreign order backlogs may also show relative resilience. Despite the sharp market reaction, a single day's trading does not indicate a sustained trend. Research on ten previous election periods by the Tel Aviv Stock Exchange found an average index recovery in the months following periods of uncertainty, even without a decisive outcome. While not a guarantee, this suggests that in the medium term, economic fundamentals, Bank of Israel policy, and the security risk premium may be more significant than election results alone. Ultimately, the stock market can recover before a new government is formed. The true test will be whether Israel can prevent political uncertainty from translating into prolonged high financing costs, as the price of indecision is measured not only in daily stock market points lost but also in the interest rates the economy may pay in the coming years, according to Dr. Ilan Gildin.