Israeli global equities, as measured by the BlueStar Israel Global Index, declined more than 4% last month, continuing the pullback that began in September.
Israeli global technology equities, as measured by the TASE-BlueStar Israel Global Technology Index benchmark, under-performed the broader Israeli equity market for the first time in five months, giving up nearly 5% last month. BlueStar's Israeli equity indices performed in-line with other Israeli equity benchmarks such as the MSCI Israel and TA-100 indices.
Many of the themes and trends that BlueStar has highlighted throughout the second and third quarters continued into the fourth quarter. This included investor preference for domestically oriented sectors of the market over global-oriented sectors, health care continuing to under-perform, especially with the overhang of the U.S. elections, and investors positioning themselves for higher growth, higher inflation and higher interest rates.
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Charts courtesy of BlueStar
The cross-currents of economic growth, monetary policy developments, political/regulatory risk, sector rotation and technical analysis are extremely complex, dynamic and fluid, but, as always, there is a place or strategy for Israeli equities to take advantage of these developments. Overall, what BlueStar sees developing in global markets is a set-up for the next leg of this bull market cycle, which began in 2009.
We come to this baseline outlook predominantly as a result of developments in global monetary policy.
The tentative coming monetary tightening cycle looks like it is both in reaction to positive economic developments and a leading indicator of positive economic developments. The state of monetary policy is that interest rates in virtually all developed markets have been, are and will likely continue to remain below the equilibrium rate for several more years, even if one takes the view that the equilibrium rate is lower than before the Great Recession.
Over the past two quarters we have seen labor markets firm, and we have seen signs of price and wage inflation. Our main thesis is that a gradually rising rate cycle will accelerate these trends, not quash them as many fear: rising rates or the perception of rising rates will induce current over future consumption through two mechanisms.
The first mechanism is best illustrated by way of example.
Suppose a person is renting an apartment or house but have been wanting to buy. Even though rates have remained at historically low levels for the past six or so years, because rates were expected to remain low the person was comfortable waiting to purchase an apartment or home.
But now circumstances have changed. It seems likely that the cost of financing a new home will rise in the immediate future, and therefore it makes more economic sense to buy now rather than wait.
This is a classic example of how expectations and rates influence consumer behavior, but it extends to companies and investment in fixed assets. In aggregate, this behavior is likely to increase demand and in turn accelerate the pace of inflation, greater corporate top line growth, higher fixed capital investment and higher global economic output.
The second mechanism is related to savings rates.
With negative and ultra-low rates, savers need to put away a greater percentage of their income in order to achieve their financial goals. However, if rates rise, then investors won't necessarily need to put away as much of their income and will have more funds available for consumption.
This path would lead to the same results as the first and they would both be supportive of equity markets.
Further support for our outlook comes from internal market behavior over the past year or so. Last month we elaborated on our assertion that investors have begun to express a preference for growth-oriented stocks/sectors over value/dividend-oriented stocks/sectors with the following statistics.
From 2014 through this past June the S&P 500 Equal Weight Utilities and S&P High Dividend indexes were up 42% and 31%, respectively, while the Russell 1000 Growth and S&P 500 indices were up just 16% and 19%, respectively. During the same time period, both developed market ex-U.S. and emerging-market stock indices were down significantly, but the middle of this year marked a turning point.
The S&P 500 Equal Weight Utilities and High Dividend Indexes are down about 11% and 1%, respectively, since June 30, while the Russell 1000 Growth and S&P 500 indices are up about 4% and 3%. The MSCI EAFE and EM indices were up 6% and 10% during the same period.
This change in market leadership coupled with the presence of major geopolitical, political and regulatory uncertainty due to convoluted messaging from global central banks, saber-rattling by NATO and Russia, and the U.S presidential election is confusing for markets. Also, the economic logic laid out above takes a bit of time to show up in the data.
These factors, as well as key technical patterns are the reasons for recent market weakness and it wouldn't be surprising if it continues through the end of this year and into the beginning of 2017.
Charts courtesy of BlueStar
Israel is notable in effectively having two economies, a domestically oriented one and globally oriented companies and exports.
The Solactive - BlueStar Israel Domestic Exposure Index, which comprises Israeli companies that get most of their revenue from within Israel, experiences periods of extreme out- and under-performance both relative to the BlueStar Israel Global Total Investable Market Index and compared with the relative performance of the Solactive - BlueStar Israel Global Exposure Index, which comprises Israeli companies that get most of their revenue from outside Israel. One of the reasons this is possible is that because of the large weight of globally oriented companies such as information technology, materials and pharmaceuticals companies in the BIGI-TIM, the correlation between the BIGI-TIM and IDEI is much lower than the correlation between the BIGI-TIM and the IGEI.
We have been watching the relative performance of our economic exposure indexes for many months, and it seems that we are now likely entering the final period of out-performance of the IDEI over the IGEI.
Although the economic news out of Israel was light last month, the economy has been experiencing robust economic growth driven mostly by sources of domestic consumption: consumer staples financials and real estate. Although there are no signs of a retreat in domestic consumption it is likely that the relative prices of Israeli equities most closely tied to those sources of consumption are nearing their upper limits vis-à-vis the prices of Israeli equities tied more closely to global trade.
We think that global investors are beginning to favor areas of the equity markets with greater growth prospects that would include those sectors represented in the IGEI: health care, materials and technology. Also, health care stocks, biotechnology and pharmaceuticals, in particular, are in technically oversold territory, despite regulatory uncertainty in the U.S.
In general, the greatest potential for acceleration in Israel's economic growth comes from its export sector which stands to benefit from growth in global trade. As investors position their portfolios for growth, Israel could be an important piece in an investor's toolbox.
Charts courtesy of BlueStar
Over the past year, the level of under-performance by some stocks as it relates to the broader Israeli equity market has been notable. Stabilization or perhaps recovery in this industry along with visibility into the regulatory environment after the U.S. presidential election could provide a major tailwind for the broader Israeli equity markets and the IGEI in particular.
We have updated the scatter plot charts below to include a point for the fourth quarter so far in which the Israeli health care Sector dropped more than 10%. The fourth-quarter under-performance of the Israeli health care sector was exacerbated this month with news that the U.S. Department of Justice issued subpoenas to several of the largest generic pharmaceuticals companies.
Also among the greatest laggards in that sector last month were several of Israel's leading biotech companies.
The chart below shows the performance of the global health care sector, relative to its benchmarks on a quarterly basis for the past eight years. Without testing for significance, we observe that the global health care sector has experienced below-expected relative performance for more than two-thirds of the three-month periods over the last year and a half, and last month added to that trend.
These charts show there is an increasing chance that the global health care sector and among it the two largest Israeli pharmaceutical companies, will have greater-than-average relative performance in several of the coming three month-periods. If this materializes, it would bode well for the overall performance of the Israeli equity market, especially given recent strong economic growth data.
Chart courtesy of BlueStar