As we were informed this morning, the rating company S&P referred specifically to the political risks in Israel and their impact on the rating. According to S&P, the independence of the Bank of Israel and the judiciary is essential to maintaining Israel’s current high rating. This is not an immediate risk of a downgrade, but as you can see in the last month, there is no doubt that since the announcement by the Norwegian Wealth Fund, and even more so since the inauguration of the government, the financial entities abroad have raised the level of awareness of the political risk in Israel.
You can see in the last month that the shekel is one of the weakest currencies in the world against the dollar, and in our estimation this is actually an outgrowth of that. To the extent that the foreign bodies become convinced that the political environment in Israel may produce economic instability, and/or a jump in the deficit and debt, so will the trend in the foreign exchange market continue. In terms of the bond market, it is worth remembering that in recent years foreign holdings in the government bond market in Israel have grown significantly Significantly, if they decide to reduce their holdings, this may lead to an increase in returns.
The next economic cycles depend mainly on the decision makers
If you take into account the combination of the strength of the economic cycle created by the corona virus – both in the recession of 2020 and in the growth of 2022-2021 with the massive inflows of money from governments around the world, it is easy to understand how we reached a situation where inflation is so high, even after putting aside the effects of the supply side. If at the beginning we still had questions about structural changes in the labor market or the “natural” inflation environment, today we can say with high certainty that in total what we saw in the last year was a normal economic cycle. Unusual in its intensity, but normal. Accordingly, we also estimate that the interest rate increases will do their job and will manage to moderate inflation back to the long-term trend. The important question for the medium term then is what is the level of the long-term inflation trend? Until the beginning of 2020, there was a clear answer to this question that is accepted by almost everyone, and that is that we live in a disinflationary world, that is, in a world where inflation will remain low in the long term and allow interest rates to be low as well. Is this answer different today? Not really.
The three main factors that made it difficult for inflation to raise its head in the years before the corona were demography, technology and globalization. Of these three, the only factor that has changed is globalization and this for two reasons: First, the energy market is expected to undergo upheavals in the coming years as a result of Europe’s desire to break away from dependence on Russia. Secondly, following the Corona, many countries realized that supply chains cannot be concentrated in just one country. On the other hand, the demographic effects of the world’s aging population are only getting stronger and technology is not really slowing down, ask GPT. Therefore, after the recession passes and with it the inflationary pressures from the labor market, it is likely that we will return to a world where basic inflation and the equilibrium interest rate are relatively low compared to the second half of the 20th century.
As far as the financial markets are concerned, this is a relatively comfortable world situation where growth comes mainly from improved productivity and technological developments and the risk-free alternatives seem less attractive. At the same time, it is impossible not to consider the risks to this forecast from the point of view of economic decision makers. On the one hand, the central banks today sound very hawkish and are determined to return inflation to its natural place, but of course it is easy to sound hawkish when the unemployment rate is so low. Even during the recession and the social and political pressures it will bring, will the central banks around the world maintain their determination? Let’s hope so, but it’s hard to say for sure.
On the other hand, the corona crisis and the governments’ treatment of the economic side of it has returned to the political discourse the ability to support the economy, after years of focusing on fiscal responsibility and trying to address the deficits and duplicate debts of the countries in the West. It is not impossible that even during the coming year the governments, which usually look mainly to the short term for political considerations, will want to use similar tools in order to support their voters. Excessive use of such tools will actually offset the effects of the interest rate and thus will not allow inflation to return to its place and/or will force the central banks to continue raising the interest rate more than necessary. By the way, in Israel, for example, this is a risk that definitely needs to be taken into account against the background of wage agreements, coalition commitments and the effect of government policy on the dollar exchange rate. Bottom line, traditional problems are solved with traditional tools and that is exactly what is happening now in the economic cycle. The interest rate hikes will cool down the global economy and return inflation to its place, this is of course assuming that the decision makers will do what they need to do, even when the situation will be more difficult than the current one.
**The author is the chief strategist of Psagot Investment House**