Israeli Markets Brace for Election Uncertainty With Four Scenarios

Israeli financial markets showed mixed signals leading up to the 26th Knesset elections, with stocks rising while bond market caution increased. On the day before the vote, the TA-125 index climbed 1.8%, the TA-35 index rose 2%, and the real estate index led with a 2.1% gain. The dollar also weakened, falling 0.7% to around 3.08 shekels on the day before the election and continuing to drop to approximately 3.04 shekels on election day, a 2% decrease over two days. By evening, it was trading around 3.02 shekels.

Despite the stock market optimism, investors appeared to be preparing for volatility. The cost of insuring Israel's debt, measured by five-year Credit Default Swaps (CDS), increased from around 52-54 basis points in mid-September to approximately 63 basis points by the previous weekend. This divergence between stock market gains and bond market caution highlights why four distinct scenarios are being considered as vote counts begin.

An analysis by the Tel Aviv Stock Exchange research unit, examining ten election cycles since 2003, revealed that in elections without a clear government outcome in 2019, the TA-125 index was, on average, 5.3% lower three months before the vote compared to five months prior. In contrast, elections that resulted in a government saw only a 0.2% drop in the same period. However, five months after the vote, this gap nearly disappeared, with cumulative returns of 6.7% in indecisive elections versus 6.5% in decisive ones. In the year following elections, the index averaged a 16.4% return, compared to a long-term average of 11.5%, though this data is based on a small sample and some years coincided with global economic recoveries.

The four potential scenarios discussed are: a political stalemate, a change in government, continuity of the current bloc, and security escalation. A stalemate, considered likely given recent poll data showing neither bloc close to the 61-seat majority needed, would mean the country operates under a continuing budget, limiting new spending and potentially government debt issuance, which could support government bonds short-term. However, delaying budget decisions for 2027, deficit, and defense spending could increase risk premiums. A change in government was projected by J.P. Morgan in August to strengthen the shekel by 2-3% due to reduced concerns about institutional changes and improved relations with Western allies, potentially benefiting banks, insurance, and real estate companies. Continuity of the current bloc could lead to a 3% weakening of the shekel and rising bond yields and CDS, while defense and export companies might benefit from a weaker currency. Foreign investors have shown caution, with global funds holding Israeli stocks at an all-time low. The most severe scenario combines any political outcome with a security escalation around the vote, expected to trigger a flight to safe assets, currency devaluation, a jump in risk premiums, and declines in consumer-dependent stocks, exacerbated by oil prices around $110-$115 per barrel.

Historically, the stock market tends to punish pre-election uncertainty and recover in the subsequent months. However, past averages were formed during periods with different security threats. The next government will be primarily assessed by the projected 2027 deficit, defense budget levels, and the trajectory of the debt-to-GDP ratio.