| Alex Zabrzynski, Chief Economist of Meitav Dash
The growth rate of the Israeli economy in the first quarter of 2022 is expected to be low: According to the relationship between the quarterly change in the Bank of Israel’s composite index and the change in business GDP over the past twenty years, a relatively small increase of 0.3% in the first quarter Low GDP. The increase in tax revenues, which from the beginning of the epidemic was a good parameter for forecasting growth, also embodies low growth in the first quarter.
It should be noted that low growth in the first quarter still reflects a significant chance of a high growth rate in 2022 as a whole due to the “edge effect” of the exceptional growth in Q4 / 21.
| The Israeli economy reaches the supply limit
Labor market data from various sources reflect a rapid tightening in its conditions to a very tight level:
• According to the Employment Bureau, the number of job seekers has dropped in March to the lowest level in recent years. The ratio between the number of jobseekers and the number of job vacancies has dropped to 1, the lowest since the data are available in 2009.
• In the first half of April, the unemployment rate in the economy fell to 2.9%, the lowest level ever. The broad unemployment rate also fell to 4.4%.
• The average wage in the business sector is growing at an accelerated pace. It is about 6% higher than the long-term trend. This is a deviation that has never happened in the last twenty years. The increase in wages in the business sector is not just a result of the increase in wages in the high-tech field. The average salary in the field of computer programming has increased by about 11% since the beginning of the epidemic, in research and development centers by about 15%, while the average salary in the entire business sector has increased by about 12%.
• On the other hand, following the wage freeze in the public sector, the average wage in the public services sector has fallen below the long-term trend. However, it is very likely that in light of the rise in wages in the private sector and high inflation, workers in the public sector will demand a significant wage increase next year.
It should be noted that total wages in the economy are growing at a very fast pace and have already exceeded the long-term trend.
All data indicate that the Israeli economy is reaching supply constraints, which is leading to a rapid rise in wages in the business sector that supports pressure to raise prices beyond the temporary effects of rising prices of imported products. All this is happening against a background of much stronger demand than “normal” demand, which is defined by the long-term trend. In these circumstances, the risk of inflation in Israel is at a high level and should cause faster restraint by the Bank of Israel.
| Acute shortage of dollars
The weakening of the shekel intensified against the background of declines in the stock market and the rise in yields in the US. The shekel was among the weakest currencies since the beginning of the year against the dollar. Reality, as well as demand for dollars from local investors, is causing the shekel to weaken rapidly.
An increase in the risk of inflation and the warming of the labor market increase the chance of a rise in interest rates
In the past week, there have been a number of developments that are expected to affect inflation in Israel:
• Following the weakening of the shekel against the dollar by about 5% in April, it managed to fall by another 2% since the beginning of May. In the short term, there will be an effect mainly on the price of fuel and travel abroad, but the stay of the NIS at these levels over time is expected to affect inflation according to a transmission coefficient of about 10%.
• Coal prices have risen by about 25% since the beginning of the month and have completed a 123% increase since the beginning of the year. Coal prices affect electricity tariffs in Israel.
An increase in the risk of inflation and warming of the labor market increase the chance of a faster rise in the Bank of Israel’s interest rate. The Bank of Israel’s interest rate in another year, which is reflected in the yield of one year, which was issued last week at a yield of 1.15%, stands at about 2%. A similar interest rate is also embodied in the IRS interest rate curve.
This forecast indicates that the Bank of Israel will increase by 0.25% in 7 of 8 meetings during the coming year. Recall that according to the forecast of the Research Division of the Bank of Israel, the interest rate in one year will reach 1.5%.
The Bottom Line: In light of recent developments, we are updating the forecast for a rise in interest rates in a year’s time to 1.75% -2.00%.
| Signs of a slowdown in the expansion of activity in the American economy
U.S. economic activity is weakening, as evidenced by a decline in Manufacturing and Services Purchasing Managers’ (ISM) indices in April. Both indices are significantly higher than 50.
| Despite the slowdown, the US labor market is not expected to weaken
Compared to purchasing managers’ indices, in the US labor market it is difficult to clearly identify signs of slowdown. Jobs continued to grow rapidly, with over 400,000 jobs added in April, similar to March. The unemployment rate remained stable and the average wage continued to rise, albeit at a slightly slower pace than in previous months. Despite rapid growth in jobs, the number of job vacancies reached a new high in March.
The labor market is usually a backward indicator of activity in the whole economy. This time, the effect of the slowdown in economic activity on the labor market is expected to be not only late, but also particularly small for two main reasons:
1. The U.S. labor market is still short of about 6.7 million jobs compared to the level it would have been if it had not been for the plague. This number is higher than the number of unemployed, which stands at 5.9 million. In this situation, companies that suffer from an acute shortage of workers will avoid layoffs even if there is a slowdown in economic activity.
2. An increase in demand for services is still expected due to the decline in morbidity. An increase in demand for services is likely to continue despite the slowdown, which is expected to support recruitment to this labor-intensive sector.
Under these circumstances, the potential for a slowdown in the U.S. economy to the labor market, even a relatively sharp slowdown, is likely to be moderate.
| What does the markets’ response to the Fed’s announcement say?
The US bond market responded to the Fed’s announcement in a not entirely routine way:
• Interest rate expectations at the end of 2022 and 2023 embodied in contracts fell slightly by 0.1%, probably following the governor’s statement that a 0.75% rise in interest rates was not discussed at the meeting.
From the announcement until the end of the week, there has been a significant increase in the steepness of the yield curves, real and nominal, with a significant increase in the long yields and a small decrease in the short.
• Inflation expectations have risen slightly, especially in the long run.
In principle, the process of raising interest rates should be accompanied by a decrease in the steepness of the curve. A rise in long-term yields while a sharp rise in the steepness of the curve, as happened last week, could signal that interest rates are not rising enough to curb inflation or indicate an increase in fiscal risk.
The US bond market did not appear to be frightened last week by the fiscal risk. The announcement of the balance sheet reduction exactly matched expectations. Also, the US Treasury Department’s issuance forecast published last week was lower than expected.
The market is more likely to cast doubt on the Fed’s willingness to fight inflation resolutely, as evidenced by the “softening” of the Fed’s curb message provided by the governor by saying it was removing the 0.75% rate hike option. On the day of the announcement itself, the market was actually happy to hear the message. However, the panic expressed in sharp declines in equities and sharp rises in bond yields arose a day after an interest rate decision in which the labor unit cost and productivity data for the first quarter were published:
• The cost of the work unit rose in the first quarter to a rate of 7.2% compared with the corresponding quarter last year, the highest rate since the 1970s. This figure is closely related to inflation, the so-called “inflationary spiral”.
• The effect of a sharp rise in labor costs on business sector commodity prices could be offset by improved productivity, but first-quarter productivity fell by the largest rate since 1993, raising even heavier concerns about inflationary developments.
• This decline in productivity is also a negative line regarding the profitability of companies.
In our view, the conclusion that emerges from the developments in the markets after the Fed announcement indicates that investors who previously feared an excessive rise in interest rates while underestimating the risk of inflation, are now more afraid of inflation becoming a more dominant risk. Under these circumstances the best thing a central bank and not just the US can do is send a message that it will do everything in its power to curb inflation without “softening” attempts to “please” the markets.
| The rise in long-term yields in the U.S. is nearing its peak
We think the long-term yields in the US are nearing their peak in the current rate hike cycle:
According to the contracts, the Fed is expected to raise interest rates by 0.5% in the next two meetings and by 0.25% in the three remaining meetings by the end of the year, so that by the end of the year it will reach 2.7% (mid-term). Given the increase in the risks of a slowdown in economic activity that may disrupt the rise in the Fed interest rate, this seems to be a reasonable scenario.
• It will be recalled that in a review at the end of March we estimated that above the Fed interest rate of 3% -3.5% the cost of debt service of American companies will reach levels that will cause widespread damage to their financial capacity. Long-term yields have now risen above 3% and also mark the expectation of interest rates at the peak of turnover. Yields above this range are not expected to remain over time.
Finally, we note that in the coming months the rate of inflation in the US is expected to decline. A slightly reassuring message to the bond market.
The Bottom Line: The risk of a continued rise in long-term yields in the United States has diminished. In light of this, and against the background of a rise in the Bank of Israel’s interest rate curve, we are raising the recommended yield from short-medium to medium-term.
| Gradually increase exposure to stocks
At the same time as extending the recommended maturity in the bond market, we are also raising a recommendation for the stock market for medium exposure. Beyond the fact that the stock market has already declined at a fairly large cumulative rate since we lowered the stock recommendation, here are the additional reasons for the change:
• We estimate that the rise in the Fed interest rate has already been largely reflected, as we explained earlier. Hence, no further significant increase in yields is expected, which was one of the reasons for the declines in the stock market, especially in growth stocks.
• The risk of a significant US recession is relatively low. As we have shown before, the state of the US labor market is expected to be relatively strong even in the event of a significant slowdown in the US economy. Americans are also witnessing a record increase in U.S. consumer credit in recent months, as reported on Friday.
• Companies also hold very large liquid balances and continue to invest at an increased rate.
• A strong labor market exists not only in the US but also in many developed countries. Unemployment continues to fall in most countries and the number of job vacancies is at a very high level.
• According to the survey of private investors in the US, they are quite pessimistic. It seems that a lot of “hot money” has already come out of the market.
• The future profit multiplier of an equal weight index has dropped to 16.2 compared to the average of the last 30 years which stands at 17.2. The multiplier of the S&P 500 stands at 18.1 and is close to a historical average of about 17.5.
Another indicator that could mark a change in the stock market is the common correlation of stocks in the S&P 500 that is approaching levels where the stock market has passed the “bottom” in episodes of declines over the past decade, except for the unique March 2020 event.
The biggest risk to the economy and the stock market right now are the consequences of the war in Ukraine and China’s dealing with the plague. It is difficult to estimate how long these events will last and their potential damage.
The Bottom Line: We raise a recommendation for the equity channel for medium exposure. We recommend gradually increasing exposure to growth stocks, particularly technology.
The writer is the chief economist of Meitav Dash Investment House. This analysis is intended for the purpose of providing information only, and in no way should it be considered an opinion, offer, recommendation or advice / marketing for the purchase and / or holding and / or sale of securities and / or the financial assets described therein. The information contained in this review does not purport to contain all the information necessary for a potential investor and does not purport to constitute a complete analysis of all the facts and details appearing therein. This review is not a substitute for investment advice / marketing that takes into account the data and special needs of each person. Meitav Dash Brokerage, and its sister companies and other companies in the Meitav Dash Investments Ltd. group and / or stakeholders for any of the companies listed above and their clients, may have an interest in the securities and / or financial assets included in this review.