Small Israeli Market struggles in the Big Pond

After years of outperformance as a big player in a small investment pond, Israel’s financial market is struggling on the open sea, and regulatory reforms and the risk of war means it could lag global trends for some time.

Despite the country’s still robust economy, the Tel Aviv stock index has fallen far behind its peers since its mid-2010 upgrade from emerging to developed market status, which has led to an exodus of foreign investors.

A clampdown on tax breaks has hit Israel’s sovereign debt market, while broader sentiment has been damaged by post-Arab spring concerns about the stability of the more than 30-year Israel-Egypt peace accord and the threat of a conflict with Iran that would send shockwaves across the globe.

“It doesn’t have anything to do with the economy when your (index) weighting is so small no one will take the time to look,” Haim Israel, deputy head of EMEA research at Bank of America Merrill Lynch, said.

“Will you spend time on an asset that even if it doubles will make you 0.6 %?”

Active investment flows have largely dried up since Israel’s equity market switched from comprising 3.5 % of MSCI’s emerging markets basket to being less than 0.4 % of the developed index, as Reuters stated.

Last year the Tel Aviv 100 index fell 21 % compared with a flat S&P 500. It is up 7 % so far in 2012 but still significantly lags other developed and emerging markets, as Reuters stated.

Daily volumes have sunk to an average of $200 million from $550 million in 2010, with foreign participation dropping to around 5 % from 20 % a few years ago.

Tel Aviv Stock Exchange head Ester Levanon said that the country had “fallen between the cracks” for foreign investors, meanwhile, fiscal reforms have driven Israeli institutional investors who used to keep most of their money in the country to park more funds abroad.

While the economy remains healthy – it grew 4.7 % in 2011 and should expand by least 3 % this year – the market downswing is taking its toll on Israel’s investments banks.

The Clal Finance brokerage cut pay by 8.5-10 % for those earning over 20,000 shekels ($5,400) a month while DS Apex Holdings is swallowing up rival Meitav Investment House.

The industry has been hit by a raft of reforms, including ending tax exemptions for foreigners on bills and short-term bonds, hiking capital gains tax to 25 % from 20 and taxing natural resources more heavily.

Following a wave of consumer protests last year, the government also cut the fees that fund managers charge clients and aims to break up some of the country’s largest players to boost competition, fuelling resentment among bankers.

One regulatory overhang was lifted when banking supervisor set a minimum core Tier 1 capital ratio of 9 % for banks by the end of 2014, boosting lenders’ shares by 10 %.

That uncertainty contrasts markedly with the assurance Israel Securities Authority chairman Shmuel Hauser, who recently rejected the notion that rules were harming share performance.

“Regulation, which guarantees the existence of a fair, efficient and sophisticated capital market is a critical factor for attracting foreign investors,” he said. “You cannot blame the fall in turnover on regulation.”, but for the time being, foreign money is staying away.

Outflows abroad from the Tel Aviv stock market totalled $2.5 billion in 2011 compared with inflows of $9 billion in 2010, according to Bank of Israel data.

Israeli pension funds and insurance firms are also looking overseas. Though still 70 % invested in Israeli government bonds, of the nearly 30 % they hold in stocks, around half is held overseas – more than double the amount of two years ago.

“Israeli institutional investors made a smart decision to start allocating some of their money abroad. It’s happening very fast right now,” Merrill Lynch’s Israel said.

Capital flight has turned markets sluggish, fuelling concerns of what might happen to local investments if Israel attacked Iran to prevent it from acquiring nuclear weapons.

In the absence of a breakthrough on Iran, Israeli markets might underperform for the rest of the year, Meitav’s Shai said.

In the past, the Tel Aviv bourse has largely shrugged off geopolitical issues. During the 2006 war with Hezbollah in Lebanon, shares plunged 12 % the first 2-1/2 days but quickly erased losses, and the market hardly blinks at Palestinian rocket attacks into Israel from the Gaza Strip, but broader implications make the Iran situation different.

“There is no concern in a war with Lebanon that the Eilat port will be closed or ships can’t go through the Suez Canal,” Psagot’s Herzog said.

Meanwhile, Israeli assets are getting cheaper, so the temptation to reinvest in a market with still sound fundamentals is unlikely to go away.

“You have got a few catalysts to turn things around. One is a resolution of the Iran concern – could be political or military,” Herzog said.

He added “Having the uncertainty lifted will be a catalyst in terms of volume and performance” and “When we have a few more years of above-trend growth, then it will be possible to value companies based on fundamentals rather than external concerns.”