Financial markets have been a whirlwind these past few weeks, and for good reason. Surprising macroeconomic figures and dramatic security and political events around the world have made volatility the name of the game.
“You only have to look at the past month and see the series of events we have seen: the attempted assassination of Trump, Biden stepping down as a candidate for another term and being replaced by Kamala Harris, in Israel a drone from Yemen arrived in Tel Aviv, our attack on Yemen, assassinations near and far,” says Ofer Klein, head of economics and research at Harel Insurance and Finance. “We have seen major shocks in the capital market after months of rallies, both from Japan and from the United States. The system has been shaken.” Klein has been in his current position for over a decade. He is a member of all the group’s investment committees, and has previously worked at the Bank of Israel and the Finance Ministry.
Globes spoke to him about the turmoil in the markets, what will happen to interest rates in the United States and Israel, and his optimistic view of the Israeli economy and the shekel after the war.
“Expectations are completely overblown, and the Fed is not going there.”
Ofer, let’s start by reviewing the turbulent week the markets have had. What really happened?
“Looking at the macro situation, we can see several clear trends. Global inflation is coming down, but slowly. Why? Because the labor market is still strong. It is true that there have been some numbers released recently that have put pressure on the markets, but when we look at the labor market in the US, the unemployment rate is still low – 4.3% in July. On the other hand, wages in the US are still rising very quickly.
“The United States is a service-based economy, and the main input into services is workers and wages. When wages are rising at a rate of 3.5% to 4%, it is difficult to see inflation coming down as quickly as we would like.”
U.S. employment figures for July were weaker than expected, showing a surprise rise in unemployment. The stock market reaction was a sharp drop in Wall Street’s leading indexes, and hints that the Federal Reserve missed the coming recession, just as it missed the inflationary wave when it started.
The market seems to be very concerned about the high unemployment rate.
“We’re not talking about 10%, we’re talking about 4.3%. What’s worrying is the pace of growth; it started the year at 3.7%. I’m even more worried when I look at the numbers. In July, 114,000 new workers joined the U.S. economy, but 70% of them were in education and health. And in the sectors where we want to see growth, like high-tech, there have been layoffs. That’s more worrying in my opinion.”
Markets now expect a large rate cut in September, from 5.5% to 5%.
“True, but expectations are one thing and events are another. The market is in a manic depression. Going back a few months, the market expected six rate cuts in six months. But after two numbers that indicated the strength of the US economy, it shifted to expectations of no rate cuts at all this year. Now, after one weak number, the market is again talking about a sharp rate cut this year, 1% in two months. That is exaggerated on the other hand. The Fed will not go that far. In my opinion, it will act more moderately. I estimate that we will see a 0.25% cut in September and another 0.25% in November.”
What next number do you think could move the markets?
“The US CPI, which is due out next Wednesday, is too early to be praising inflation. As long as wages are rising at about 4% a year, it is hard to see inflation abating. This number could turn markets upside down again, but in this regard it is important to remember that I do not recommend trying to time the market, but rather looking at the long term.”
“The war will pass, and then there will be recovery.”
Ofer Klein knows Israel’s financial institutions from every side, from the private market side to the Finance Ministry and the Bank of Israel. At this point, he’s not too worried about the country’s macroeconomic numbers, but he’s outlining things he says should happen the day after the war. “We entered the war from a very good position,” he says. “The debt-to-GDP ratio was 60%. We ended 2023 with 62%, and according to estimates we’ll end this year with 67%. In global comparison, our situation is still not bad. Even if the debt-to-GDP ratio continues to rise, the OECD average is around 75%. As long as we can stop, and start reducing the debt-to-GDP ratio, we’ll be fine. But again, we have to remember that we started from a good position, in unemployment and inflation as well.”
Who will pay this debt?
“Obviously, the war will have a big impact. Wars cost a lot of money, and they have to be financed. And when you ask who is going to finance them, as in any other country, most of the burden falls on the middle class, which could hurt consumption in the future.”
Should the rising fiscal deficit be a concern? The target for this year is 6.6% of GDP, and we are very likely to exceed that. The deficit in July was already 8.1% annualized.
“It doesn’t matter whether the government raises taxes now, which will hurt consumption, or whether it raises the deficit, which means higher taxes in the future. Either way, we will have to pay. In the Covid pandemic, the deficit went up to 12%, not to 7% as it is now. The pandemic has passed. War is not a permanent thing. It will take time, it is painful, and we will see a rise in the deficit. But the war will pass, and after the war there will be a recovery.”
“In practice, the market has already downgraded our credit rating.”
Credit rating agencies indicate that Israel’s credit rating may be downgraded again.
“Absolutely. The thing is, the market has already priced this in. When you look at Israeli government bonds in dollars versus U.S. government bonds, you can see our risk premium. Our risk premium is about 200 basis points. When you look at countries around the world that have reached these levels, we are talking about worse than Italy, which is rated BBB-, and Romania, which is also rated BBB-. So a downgrade is not a big threat, because the market has already downgraded us. Will it have a big impact on the market? I don’t think so; the risk premium has already been priced in. Will it get worse? Anything can happen.”
How does this risk premium affect us as consumers?
“Rising interest rates over the long term affect you when you borrow. Ultimately, when you take out a mortgage, interest rates are higher. It affects everyone’s ability to access credit and buy things. Ultimately, interest rates hurt businesses, too, because businesses rely on credit. Nobody works with just the cash in their pocket. So businesses are hit with two hits—their costs go up, and consumers have a hard time getting credit, so they buy less.”
Who do you think we should pay the most attention to here in Israel?
“The quickest measure is the foreign exchange market. It gives an immediate picture. If the exchange rate jumps, I know something has happened. It’s the closest measure to the markets.”
If we look at the foreign exchange market, the shekel rate against the dollar is quite high. Will the decline continue?
“I hear a lot of people saying ‘the shekel will strengthen’ or ‘the shekel will weaken’ in the next month. There is really no way to decide. A coin flip will really do the trick. In the long run, after the war, I think the shekel will strengthen because of structural factors in Israel. We have a current account surplus in the balance of payments. That means that in the end, more dollars are coming into Israel than are going out. Add to that the American aid we receive every year. In addition, the Bank of Israel’s foreign exchange reserves are over $200 billion, the third highest in the world as a percentage of GDP. That’s a big safety cushion.”
“Despite the war, our interest rates will also fall.”
All over the world, interest rates are falling rapidly, but that is not on our agenda at the moment.
“The Israeli economy cannot remain an exception to global interest rates for a long time. This could lead to a significant strengthening of the shekel, which the Bank of Israel does not want, or a significant weakening of the shekel, which the Bank of Israel does not want. It is possible that we will deviate from the global trend for a limited period. For example, when there is a war and risk premiums rise, it is possible that we will keep interest rates slightly above the global equilibrium. When I look to the future and see interest rates falling in the United States, Canada, Britain, the European Union, Switzerland, Brazil and every other country except Japan, our interest rates will eventually fall as well, despite the war.”
In conclusion, Klein believes that we will see a recovery in the Israeli economy after the war. “A large part of Israel’s GDP is made up of private consumption, but there is also investment and government consumption. Generally, when infrastructure is hit—an earthquake, a war, whatever—once the event is over, the rehabilitation phase begins, and we see greater economic activity. GDP is basically a measure of economic activity. I think we will see annual growth of 4% to 5%. That’s what has happened every time in the past.”