Josh Kaplan & Steven Schoenfeld: BlueStar Israel Equity Market Review and Outlook–July 2012 in Review & August Outlook
By Josh Kaplan and Steven Schoenfeld of BlueStar Global Investors LLC for IsraelStrategist.com, August 15, 2012
This monthly column written by the staff of BlueStar Global Investors, a financial information firm focused on Israeli investments, provides an overview of trends and developments in Israel’s dynamic economy and capital markets. It introduces themes, sector developments, market trends, and individual company performance to potential investors, highlighting the many interactions between Israeli and global markets.
Preparing For the Worst and Hoping For the Best
In July, we were hit with a continuous stream of developments ranging from changing fiscal policy to confirmation of the Euro Zone recession’s impact on the Israeli economy, to a fairly positive start to the corporate earnings season for Israeli publicly traded companies. In the face of macro-headwinds, Israeli equities as measured by the BlueStar Israel Global Index continued feeling for a bottom in July. The positive start to August also makes us slightly more comfortable with the near-term outlook for Israeli equities.
Also in July, Israel’s energy woes continued despite the developing natural gas and oil sectors; the landscape in Israel’s financial and non-financial markets became increasingly competitive; geopolitical events especially regarding Syria, Egypt, Iran, and the Palestinians continued to unfold; and the Euro Zone continued to impact Israel’s economy.
BIGI (BlueStar Israel Global Index) Performance Versus the TA-100 and S&P 500 Indices Since 2010
Israeli global equities, as measured by the BlueStar Israel Global Index (BLS:IND), were down slightly in July as markets digested the new government budget plans and developments in Europe. In July, the BlueStar Israel Global Index declined by 0.53%; however, global Israeli equities were up 1.4% in the first week of August. Over the last few decades, global Israeli and U.S. equities have been positively correlated, though the growth nature of Israel’s economy has helped it outperform by a wide margin. In the past three quarters, however, Israeli equities have significantly underperformed U.S. equities, which we attribute to the “growing pains” of the Israeli economy and capital markets, troubles arising from the Euro Zone, and the “cold war” between Israel and Iran. However, should there be a continuation of responsible fiscal and monetary management of the domestic economy, and firm responses in both Europe and the U.S. to major fiscal and monetary issues, a rally in risk assets could be ignited and Israel could positively re-couple and outperform on the upside.
The broad Israeli equity universe – which includes companies listed in Tel Aviv, the U.S., and elsewhere – provides investors with exposure to Israel’s economy as well as exposure to several diverse and globally-oriented economic sectors.
June 2012 Sector Performance and Winners and Losers
The Materials sector gained in July on the performance of Israel Chemicals and its parent company Israel Corp. Israel Chemicals announced early in the month its plans to invest NIS 1.25 billion in a new power plant in Israel. This plant will be primarily powered by natural gas. The construction is set to commence in the third quarter of 2012 and take about three years to complete. The new plant is expected to meet ICL’s fertilizer needs for the next 20 years while lowering energy costs for the company.
For the third consecutive month, Israel’s Telecommunications and Financials sectors were among the worst, if not the worst, performing sectors of all global Israeli companies. In the beginning of July, there were several bright spots for telecommunications companies, which led the TASE higher on several occasions. Cellcom announced that it would be rolling out a low-cost and all-inclusive subscriber plan to compete with the new players in the industry. However, in a sobering report issued by Barclays Capital and detailed in a July 17th Globes article, analysts David Kaplan and Tavy Rosner assigned the sector a “negative” outlook. The Barclays analysts stated that the market has not yet stabilized and that continued regulation will prevent growth through 2012.
As for the Financials sector, July witnessed deterioration in banks, especially those with the highest exposure to mortgages; the Israeli housing market; and insurers, including Phoenix Holdings Ltd, Migdal Insurance and Financial Holdings Ltd., Harel Insurance, and Clal Insurance. All BlueStar Israel Global Index financial companies were in the red in July. The Bank of Israel is again considering tightening mortgage restrictions, as the government is raising its target budget deficit and the BOI lowers interest rates to prevent an inflationary real estate bubble. Several investment houses in Israel point out that Mizrahi Tefahot Bank would be hurt the most by higher mortgage provisions required by lenders. Life insurers fell on a report by the Ministry of Finance which estimated that rising life expectancy of Israelis will cost the big insurers between NIS 500 million and NIS 1 billion per year beginning in 2012.
On a positive note, Deutche Bank noted in an August 8th report by analyst Dan Harved titled “The curious case of Israeli Bank Valuations,” that Israeli banks have underperformed even its European counter parts which face more serious structural changes than Israeli banks do. The report also noted that Israeli banks have been among the worst performers in the world over the past year and current valuations are similar to valuations during the 2002 recession and during the global financial crisis. Deutche Bank says it may be time to consider buying Israeli banks. If this is any sign of coming support for the Israeli Financial sector (which is the third-largest group by weight in the BlueStar Israel Global Index and has been the worst performing sector in the index over the past year), then we may be looking at current index levels as a level of support for BIGI as a whole.
Profiles of Key Company Movers in May
Mellanox Technologies (MLNX:NASDAQ) is a leader in providing end-to-end InfiniBand and Ethernet connectivity solutions and services. Its products help optimize data center performance and networking issues for several markets like cloud computing, enterprises, and data centers. The company has a niche product in the growing market for cloud technologies and cheaper storage solutions. This market is expected to climb to $10.5 billion by 2014 from $3.7 billion in 2011.
Alon Energy USA (ALJ:NYSE) is an oil refiner and marketer in the U.S., with refineries spread across the country. After crossing its 200 day moving average earlier in the month, it was amongst the NYSE’s largest percentage increasers several times during the month of July. The company reported that in Q2 2012 net income tripled from the same period a year ago, though total first half 2012 net income was down from the same period a year ago. Similarly, Delek US (DK:NYSE), another company with Israeli roots and refining and marketing operations in the U.S., recently reported better refining margins, and its stock has been one of the best performers so far in August.
888 Holdings (888:LN) is an online gaming and entertainment company. Its product offering ranges from an online casino to poker to bingo.
Market Trends – Technical Analysis and Market Fundamentals
Technical Analysis of the Israeli Market
From a technical analysis perspective, Israeli stocks, as measured by the broad-based BlueStar Israel Global Index (BIGI), repeatedly tested key support during Q2 2012 around the index level of 195/200 (see solid red support line on two-year chart). As indicated by the solid black downtrend line on both the two-year and five-year charts, the short/medium-term outlook for Israeli stocks is challenging, especially with a breakout above the 225 index level needed to reassert a bullish trend. The key support levels of 194/197 have just barely held in the beginning of Q3, and BIGI must maintain the 200 index level to consider that level as new support.
The longer-term outlook for Israeli equities could become bullish only if the index breaks back into the channel connecting the 2008/2009 lows, as illustrated in the BIGI five-year chart, which spans the entire 2008-2009 global financial crisis. BIGI, like other Israeli indexes, bottomed in late October 2008 and again in early March 2009, followed by a powerful rally into spring 2010.
After a short correction, BIGI surged to lifetime highs in late 2010 through spring 2011, only to correct deeply again amidst Europe’s financial crisis, Israel’s domestic social protest and nuclear threats from Iran. It found solid support during late 2011 at the key technical level of 195. This corresponds with an uptrend beginning with the early 2009 bottom (solid red uptrend line), and the horizontal support zone dating back to autumn 2007 (solid red line), also at approximately the 195 BIGI level. As noted above, this level was repeatedly probed in June and July 2012, and appears to have held.
If the 200 level is maintained, a rally toward the downtrend line (solid black line) which began in mid-late 2011 at the 225/230 index level can occur. If this is broken, a rally to strong resistance is projected to be at 239/240, as highlighted by the solid green line. If this resistance is broken, we see the projected upside potential of the index to be the 300 level by early-2013, though likely with a consolidation at the 2011 high of 275. From a risk management perspective, the previously articulated stop-loss at the 192/194 level remains valid.
From a risk management perspective, there is a clear “stop-loss” point at the 193/194 level. And, as noted in the short-term outlook, it was being aggressively probed in early June (as European markets were making new lows) and again in early July (as Europe and U.S. markets were weak, but not making new lows). If these levels are breached and confirmed with a weekly close of BIGI below 192, the longer-term outlook will shift dramatically, and any rallies should be sold. A breach of 192 will increase the likelihood that the spring 2011 peaks represent the ‘head’ of a massive ‘head and shoulders’ pattern which would project a major decline to around 135, just above the autumn 2008/March 2009 lows. However, if these levels hold, and a rally can lift BIGI decisively above the 200 level, there is some hope that this major multi-year support level will have held, and can potentially form a base for a sustained rally later this summer. If the latter scenario develops, we would look for similar medium/long-term targets as were projected in our May Outlook, perhaps as high as the 270 level for BIGI.
Two major headwinds facing Israeli publicly traded equities are leading to declining volumes and negative investment flows by both Israelis and foreigners. In May 2012, the Israeli public’s financial portfolio consisted of NIS 374 billion of stocks, about 14.6% of portfolios. This is down from a year ago, though Migdal Capital Markets says that historically there has been an inverse relationship to the public’s exposure to the stock market and equity price performance. The Ministry of Finance is set to study the effects of the January 2012 5% increase in the capital gains tax on declining trading volumes, which have plunged over the past 12 months. In 2011 volumes on the TASE fell by 15% and volumes are down by a similar rate in the first half of 2012. One strategy for reviving trading volumes would be to include Israel in the MSCI Europe index. This would force index and portfolio managers to trade Israeli shares to gain the proper exposure to Israeli stocks.
The number one risk factor for Israeli shares remains the negative effects of Europe’s slow down on Israel’s export sector. For now, the secondary risk factors that could prolong the current downdraft are the regulatory burdens, structural reforms, and fiscal policy changes. The third risk factor in Israeli markets is geopolitical, with violence continuing in Syria, and rocket and terrorist threats from Palestinians in Gaza and militants in the Sinai. As we moved into August the prospect of military conflict with Iran is becoming a greater source of volatility for Israeli equities.
Economic and Fiscal Outlook
The slowdown in Israeli economic activity and international growth has led some analysts to lower their full year 2012 GDP forecasts. The BOI, though, reaffirmed its full year 2012 GDP growth forecast at 3.1% but lowered its 2013 growth forecast to 3.4%. In 2012, the Bank of Israel lowered the benchmark rate twice, from 2.75% to 2.5% in the beginning of the year, and from 2.5% to 2.25% on June 25th. The June rate drop decision was made in light of lower-than-expected growth in the CPI and a deteriorating situation in Europe’s debt debacle. However, despite growing expectations of a recession in Europe and a worsening European debt crisis, the BOI decided to leave the rate unchanged in July. In the past 12 months, from July 2011 to July 2012, inflation was 1% and the inflation outlook for the next 12 months remains within the 1%-3% target, with rising energy prices but lower food prices. Although the rise in home prices was stagnant over the last year, there may have been a slight uptick in Q2 2012.
The yield spread between Israeli and U.S. 10 year government bonds contracted by 4bps as Israel’s sovereign risk premium declined to levels similar to other emerging economies. Analysts believe another interest rate cut of 25bps may occur by the end of the summer. The Shekel performed similarly to most other currencies versus the U.S. Dollar and the Euro. The Shekel continues to weaken versus the U.S. dollar, and broke 4 Shekel/Dollar a few times in July and early August. On the other hand, as the Euro-zone economic slowdown and debt crisis has continued, the Shekel has made gains versus the Euro through the first half of 2012, despite weakening during the month of June.
A major story in Israel over the past few months has been the government budget deficit and credit rating outlook. The BOI estimates the 2012 government deficit to be 3.7% of GDP. The budget deficit target for 2013 has been raised from 1.5% of GDP to 3% of GDP after a months-long debate among the PM’s office, the finance ministry, and the Bank of Israel. Measures recently approved by the cabinet include a 1% increase in the Value-Added-Tax (set to take effect in September), lowering tax-bracket thresholds which will include lower income Israelis in higher tax-rate brackets, and 5% cuts in ministry budgets (the education and internal security budgets were cut by only 1% and 3%, respectively).
What to Watch For in Summer 2012:
1- Social Protests and Housing Prices: The protests that began in summer 2011 reignited recently in Tel Aviv and in some cases turned violent. High living costs and concentration of economic power are the legitimate concerns of protestors. The social protests of last summer prompted the government to take action on making Israeli financial and non-financial markets more competitive and consumer-oriented.
Steps have also been taken to lower housing prices—the housing market has been one of the hottest markets in Israel over the past few years and a major source of contention among Israeli citizens, especially those in the younger demographic segments. Housing prices continue to rise, but at a slower rate throughout the first half of 2012. The news flow regarding regulatory and policy response to rising living costs and rising home prices is quite fluid. Policy responses and trends in home prices have a significant effect on Israeli banks and Israel’s economy, so close attention should be paid to developments in this arena.
2- Energy Sector: The development of Israel’s energy sector is one of the most significant economic stories for the country. Despite Israel’s natural gas reserves, the country continues to experience electricity rate hikes as the commercialization of Israel’s natural gas reserves will take some time. In July, the Tamar field was not able to produce enough natural gas to meet Israel’s energy needs, so energy producers turned to imported gas, which can cost up to three times as much as Israeli natural gas. The natural gas authority increased its estimate for natural gas demand through 2040 by 20%. Rising demand estimates have dampened the outlook on the magnitude of an Israeli natural gas export sector. Geological surveys continue and reserve estimates are continuously updated; no final decision by the authorities regarding a potential natural gas export program has been made.
In mid-June the Public Utilities Authority approved a $20 billion, 15-year contract in which the Tamar Drilling Partnership (Nobel Energy, Isramco, Avner Oil & Gas, and Delek Drilling) will supply natural gas to the Israel Electric Corp. Following this deal, the Tamar partners signed an additional $3 billion gas supply deal with Dorad Energy, an Israeli independent power producer. Additionally, a satellite of Yam Tethys’ Mari B field, Pinnacle, has begun producing 150 million cubic feet of natural gas per day which, according to a Globes’ June 13th article, will have saved Israel NIS 650 million this summer alone. Gas also started flowing out of the Noa North field. Israel Opportunity (soon to list on the Cypriot stock exchange), which is a limited partnership of oil and gas explorations, has increased estimates of reserves in the Pelagic field to 530 million barrels of oil and 5.5 trillion cubic feet of natural gas. Some of the gas from the Pelagic field may be sold to Cyprus as Cyprus’ natural gas fields will take more time to develop.
In July, Isramco confirmed finding significant amounts of natural gas at the Shishmon 1 well and production test results are expected in late August or early September. If the test results are positive, this will be the first major reserve not developed by Delek Group or Noble Energy. ATP Oil & Gas is Isramco’s partner at this well, though the sustainability of this relationship is somewhat questionable as ATP Oil & Gas is experiencing financial difficulties.
As the need for another Oil and Gas major to assist in the development in Israel’s energy industry becomes more apparent, Gazprom is planning on opening an Israeli subsidiary to spearhead Russia’s efforts to participate in drilling, exporting and commercializing Israel’s natural gas reserves.
3-Spillover Impact from European Markets and Economies: The slowdown in the European economy and other leading emerging market economies has intensified, so we continue to watch closely to developments in this area. While Israel’s trade flows between North America, Asia, Emerging Markets and Europe are quite balanced, the European market remains the largest single market for many Israeli exports. Continued economic weakness in Europe–highlighted by Greek austerity and Spain’s bank and financial sector woes; a stronger bi-lateral exchange rate; and a contracting Euro-Zone economy– remain the biggest sources of pressure on Israel’s economy and GDP.
4-Geopolitics: The situation in Syria has shown no sign of improving as Iran continues to vow unbreakable support for the Assad regime and the U.N.’s Ban Ki-moon has abandoned his leadership role in trying to resolve the conflict. Israeli and U.S. intelligence continue to monitor the movements of Syria’s chemical weapons stockpiles on fears that an Assad regime which feels cornered may use these weapons as a last resort. Also, Israeli officials have met recently with U.S. Secretary of Defense [delete comma] Leon Panetta, and have been publicly reaffirming the U.S.- Israeli alliance against Iran’s quest for nuclear weaponry and Israel’s homeland defense capabilities against rocket fire on multiple fronts. As mentioned above, the standoff between Israel and Iran over Iran’s quest to obtain nuclear weaponry is becoming a constant source of pressure on Israeli equities.
The situation in Egypt has taken an interesting twist recently following several weeks of attempted terrorist attacks. In the latest development, a group of militants in the Sinai Peninsula killed 16 Egyptian army soldiers on an Egyptian outpost near the Israeli border. Israel has since allowed Egyptian attack helicopters and army forces into the Sinai to search for the militants and attempt to regain control of the Sinai.
Egyptian President Morsi being forced to proactively fight terror, possibly in a coordinated effort with the Israelis, could be a positive development. As the prospect of military action against Iran by Israel or the U.S. may ignite attacks from Iran’s proxies in Gaza and Lebanon, the stability of Israel’s peace treaty with Egypt is of extreme importance, though still somewhat tenuous.
Yet amidst significant geopolitical and global economic challenges, Israel’s economy continues to outperform its OECD peers, as well as many Emerging Markets. Its equity market has, unsurprisingly, been buffeted by Europe’s economic crisis and the global downtrend in stock markets. However, the long-term attraction of Israeli stocks remains intact, and the global nature of Israel’s equity market makes it naturally diversified vis-à-vis regional tensions in the Mideast. We continue to believe that a broad selection of Israeli stocks provides exposure to both global and domestic growth. Such a portfolio offers ‘the best of both worlds’ — Developed Market stability, and the demographics and growth potential of an Emerging Market. In addition, Israel’s high-tech sector – which includes InfoTech, AgriTech and DefenseTech — continues to drive technological advancement around the world. Finally, Israel’s economic policy and regulatory environment—highlighted by the government’s move to break up multi-industry conglomerates and the Bank of Israel’s astute monetary policy—should inspire the long-term confidence of investors.
Editor’s Note: Steven Schoenfeld, co-author of this article and the Founder and Chief Investment Officer of BlueStar Global Investors LLC, is also the Founder and Publisher of IsraelStrategist.com. He is the Editor of Active Index Investing (Wiley Finance 2004/Toyo-Keizai 2006/China Press 2009). Josh Kaplan is a Research Associate at BlueStar Global Investors LLC.