This is another in a series of articles that makes a fundamental macroeconomic sectoral flow analysis of the economies of key countries across the globe.
The purpose of the review is to see if the local stock market is worth investing in via exchange traded funds (ETFs). These funds are available to all investors, even for non-residents or those not able to trade in the stock market of that country directly.
In this article, we examine Israel from a sectoral flow analysis perspective to see if the private sector, containing the local stock market, is getting the support it needs from the government and external sectors to continue its march upward.
Details of the methodology employed to analyze these opportunities are available in the sectoral analysis section found later in this article.
The magic formula for success is:
P = G + X
And you can read more about that below.
Which Countries Are Doing Well?
The first port of call is the ETF page at Seeking Alpha and a look at country ETFs and how they are performing.
The chart is from early December 2016. In that time positions have changed a little as the table below shows.
Most countries on the list are in the red and are of no further interest, though we could learn from them what to avoid, as could their governments and politicians. But, as investors, we will leave that to them.
Since the start of this series of articles, Israel has moved from 29 to 31 on the list and is up 11% over the last 12 months. Israel is one of the few countries that has fallen back in the chart since beginning this series of articles. But it has not fallen far and gone from a net loss to a net positive result.
We will start the analysis with the government sector.
The Bank of Israel provides the following summary of fiscal policy:
"· The expected deficit in the State budget in 2016 is less than 2.5 percent of GDP, markedly lower than the deficit target set for this year and slightly higher than the actual deficit in 2015. The deficit is lower than the target due to tax revenues that are markedly higher than were forecast when the budget was being compiled. This is due to more rapid than expected growth in consumer goods imports and wages, and the continued high volume of real estate transactions.
· The proposed budget for 2017 and 2018 raises the deficit target to 2.9 percent of GDP in each of those years, well above the present targets of 2.5 percent in 2017 and 2.25 percent in 2018.
· In light of the increase in the deficit target, and based on current macroeconomic forecasts, it appears that implementing the measures incorporated in the proposed budget will essentially lead to meeting the government's new deficit targets in 2017 and 2018.
· Increasing the deficit target for 2017 and 2018 despite the strength in tax revenues primarily reflects a marked increase in the expenditure ceiling-by about NIS 12 billion in 2017 and by about NIS 16 billion in 2018 (including about NIS 8 billion in respect of non-adjustment of prices)-further to the increase in the ceiling in the 2015 and 2016 budget.
· The increases in the expenditure ceiling in recent years-alongside the increasing use of accounting adjustments, use of one-off transfers from extra budgetary entities, switching of revenues between years, and spreading expenses-indicate the difficulty in achieving the government's objectives in the defense, welfare, and social services areas within the framework of the budget determined by the ceiling, and that the expenditure rule has exhausted its ability to serve as a barrier to pro-cyclical policy.
· The price adjustments lead to marked fluctuations in the expenditure ceiling, resulting from the gap between the price level forecast when preparing the previous budget and actual inflation. To prevent such fluctuation, there should be a switch to nominal budgeting based on the midpoint of the inflation target.
· The government plans to reduce corporate tax rates and personal income tax rates. The reduction will lower revenues mainly beginning in 2018, as in 2017 most of it will be offset by an increase in taxes on employers' allocations to severance pay funds for high-wage employees, on owners of three or more homes, and on members of a kibbutz.
· Given that the economy is close to full employment, and in light of the decision to approve a two-year budget, it is important that the budget focus on measures to increase productivity-particularly an upgrading of human capital and of physical infrastructures-alongside improvement in the regulatory environment.
· At the planned deficit level, the debt to GDP ratio is expected to increase moderately in coming years. Against the background of the employment environment and high tax revenues, policy should lead to a decline, or at least stabilization, of the debt to GDP ratio, in order to allow fiscal policy to contribute to the economy's dealing with periods in which macroeconomic conditions will be less positive.
· In accordance with the amendment to the Foundations of the Budget Law from November 2015 (the "Numerator"), the government is required to correct, when approving the current budget, expected deviations from targets in the 2019 budget as well. Given the proposed measures in the budget, expected expenditures in 2019 are about NIS 8 billion higher than the increased expenditure ceiling proposed in the budget. Without adjusting this deviation, the deficit in 2019 is expected to be 3.5 percent of GDP. It is imperative that the government carry out the required adjustment to halt the increase in the deficit and to maintain the reliability of this important amendment to the law.
· The experience of the recent past in Israel and worldwide indicates that strength in tax revenues that is based on developments in specific markets may dissipate rapidly and lead to a rapid increase in the deficit. Therefore, the risks incorporated in the current permanent increase in expenditure together with the reduction in the revenue base, are significant."
(Source: Bank of Israel)
The fiscal news is relatively good with a planned and sustained boost in government spending and expansionary policy. One reads with mirth that their American-inspired self-imposed fiscal spending constraint cannot be maintained as it has exhausted its ability to act as a barrier to pro-cyclical policy. Hopefully, they will see the pointlessness of this debt ceiling policy and quietly drop it. Other things that are nice to read is the recognition of the need to invest in human capital (read people) and infrastructure.
One can expect expansionary policy to take place and be sustained which is very good for the private sector.
The chart below shows the government budget picture.
The Israeli government has been a net add to the private sector long-term.
The average net add over the long term is five percent of GDP and in times of war, such as the early 1980s much higher. "Operation Peace for the Galilee," and the invasion of Southern Lebanon was a major fiscal undertaking and the reason for sustained fifteen percent plus deficits. War is very expansionary.
The next chart shows the value of the budget and a measure of how much money is added or drained from the private sector by the government sector.
The chart shows that over the long term the government has been a positive and growing help to the private sector. Every year for the last decade the government has injected more and more money into the private sector. Because the economy has grown in this time the dollar amount has grown even though the amount as a percentage of GDP has remained much the same year after year. This is a very positive trend and one that we have only seen in India in this series of articles. This trend is better though as the total dollar amount is increasing as well, whereas in India it was falling.
Israel has the following tax rates:
(Source: Trading Economics)
The rates of taxation are relatively high and skewed heavily for business with a 25% corporate tax while the wage earners are paying a 50% top marginal rate plus a 17% consumption tax on all they buy. The financial misery of the consumer goes on with the likelihood of a very high mortgage with which to afford his overpriced accommodation as the chart below shows.
The chart above shows that the cost of housing has increased four-fold since 1990 and took off after 2008 and did not suffer a dip due to the GFC. In most other countries the GFC caused a significant dip in average house prices. Despite the relatively high home prices the rate of construction has not slowed as the chart below shows.
The Israeli government is the sovereign issuer of its currency unit; as the source of all money in the economy it does not need to obtain funding from the private sector via taxation or borrowing. This sort of economic thinking shows that the government is acting as if the gold standard still exists and that its spending needs to be squared off against a fixed quantity of gold; this has not been the case since 1971.
The picture gets worse when one reads that the government has a self-imposed debt ceiling, that it keeps breaking. If one also has the self-imposed tradition of issuing a government bond to match deficit spending then of course one will break these self-imposed constraints each time the money supply is expanded to match the number of GDP transactions taking place.
This paints a picture of a government that is not aware of its currency creation powers, is obsessed with debt and driven by a now redundant gold standard budgeting mentality, and is unaware of its role as the provider of the medium of exchange.
Given Israel's precarious security situation, surrounded by enemy states that decline to recognize Israel's statehood and have unsuccessfully invaded a number of times, it cannot allow itself to be economically weak and thus militarily weak. Israel has a strong incentive to throw off the redundant gold standard thinking and embrace modem monetary thinking to survive.
Taxation that dampens aggregate demand and creates enormous and unnecessary tax collection dead-weight losses could be dropped and that resource more productively allocated.
Fiscal policy that is hemmed in by self-imposed constraints, such as debt ceilings and bond issuance, expanded by dropping those artificial constraints.
Expanding the money supply, debt free and not at interest, within the limits of set inflation, employment and currency exchange rates could begin. This is a far more intelligent basis than the current "old think."
The chart below shows the long-term balance of trade position.
The chart shows Israel has a poor balance of trade position and that it is trending worse rather than better.
Regarding real goods, though, Israel is materially better off as it has traded computer credits for real resources. Computer credits are in infinite supply whereas real assets are finite.
The chart below shows the capital flow situation.
The chart shows that the capital flows are a net positive. Since the GFC crater in 2010, the trend has improved to a net positive result after a decade of net outflows and decades of neutral flows before that.
The chart below shows foreign direct investment.
Foreign direct investment is a positive picture and since peaking in 2015 has declined since. The GFC boom-bust saw a reversal of the positive trend in the years prior, and since 2013 the positive trend has firmly resumed. FDI shows that foreign business people are investing in Israel and see future profits and growth there. This is a strong vote of confidence.
The chart below shows the current account situation.
The current account pulls it all together and shows that when one considers the external sector's total impact, it is a net add to the private sector. The trend since 2005 has been strongly upwards, thanks to capital inflows and FDI offsetting a negative balance of trade.
One can see the whole trend when one compares GDP with the amount of money in circulation, shown in the following two charts:
Both charts show an upwards trending growth profile overall, though GDP has fallen in the last year after many years of healthy growth.
GDP has fallen of late and the money supply has not. This should lead to inflation and the chart below shows that this is indeed the case.
The inflation rate is creeping higher after many years of decline and more recently deflation. At less than 1% it is still ultra low by any standard. This means the Israeli government has fiscal space to create more currency and spend it into being on public health, education and infrastructure or lower tax rates or both. Lowering tax is a good deal easier than making and building things and can have an immediate impact. This would be popular too as the average consumer is highly taxed and loaded with debt.
Israel enjoys a high and growing employment rate as the chart below shows. Israel proves that one can have high employment and low inflation, even deflation at the same time. Economic thinking that says you can have one and not the other is clearly false; you can have both at once. NAIRU, the Phillips curve, and the Laffer curve have no place in Israel; in fact, Israel debunks them roundly.
In this series of articles this is the strongest employment growth chart that I have seen.
One can achieve inflation in two ways. One is positive in that the government puts too much money into circulation and the other is negative in that the economy shrinks and produces less while the money supply rises or stays the same. Greece and Sweden are examples of the latter.
Sectoral Analysis Methodology
Each nation state is composed of three essential components:
The private sector
The government sector
The external sector
The private sector comprises the people, business and community, and most importantly for investors, the stock market. For the stock market to move upward, this sector needs to be growing. This sector by itself is an engine for growth and innovation. However, it needs income from one or both of the other two sectors to grow in value.
The government sector comprises the government with its judicial, legislative and regulatory power. The key for the stock market is that this sector can be both a source of funds to the private sector through spending and also a drain on funds through taxes.
The government through its Treasury also sets the prevailing interest rate and provides the medium of exchange. Too much is inflationary and too little is deflationary. It puts the oil in the economic engine and can put in as much as its target inflation rate allows. It is not financially constrained, for a sovereign government with a freely floating exchange rate any financial constraint such as a matching bond issue is a self-imposed constraint. A debt ceiling is also a self-imposed constraint.
The external sector is trading with other countries. This sector can provide income from a positive trade balance, or it can drain funds from a negative trade balance.
One should note that a negative trade balance also means that a country has traded currency, that is in infinite supply, for real resources that have a finite supply.
For the stock market in the private sector to prosper and keep moving upward, income must enter the flow. Otherwise, the sector can only circulate existing funds or is being drained of funds and is in decline.
The ideal situation is that the private sector has a net inflow of funds and is constantly growing, thus giving the stock market headroom within which to expand in value. For this to happen, one or both of the other sectors have to be adding funds to the circular flow of income.
The following formula expresses this simple relationship.
Private Sector [P] = Government Sector [G]+ External Sector [X]
P = G + X
For the best investing outcome, one looks for countries where the government sector and external sector are both net adding to the private sector and causing the local stock market index to rise with the receipt of additional funds.
Israel is a buy. Our assessment criteria are met in that both the government sector and external sector are net adding funds to the private sector and this is finding expression in expanding house prices and the stock market.
When one looks at the sustainability of the income flows one can read that the government plans to continue its supportive expansionary policy for many years going forward. External flows show a trend upwards and have sustained for many years in what looks like a long-term structural trend upwards, based on Israel being the most advanced country in the region and a center for innovation upon which its neighbors reluctantly draw, despite their differences and wars.
Investors taking the positive investment view of Israel could try the following ETFs:
iShares MSCI Israel Capped ETF (NYSEARCA:EIS)
VanEck Vectors Israel ETF (NYSEARCA:ISRA)
BlueStar TA-BIGITech Israel Technology ETF (NASDAQ:ITEQ)
The next article takes us to the nation that called Israel back into existence after the Second World War: The United Kingdom.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.