ISRA - iShares MSCI Israel ETF: Strength In Diversification

2023-10-26 17:48:43 ET

Summary

• EIS has declined by 15% since the start of the Israel-Hamas war.
• While the conflict is pressuring the Israeli economy, we highlight how the EIS portfolio includes companies with a more global profile operating internationally.
• Expect the volatility to continue including through a weaker Israeli Shekel currency although we see room for the fund to rebound longer term.

The iShares MSCI Israel ETF ( EIS ) is likely far down the list in terms of important topics that matter for the millions of people impacted by the ongoing crisis in the Middle East. We've all seen the devastating images and it's clear that the situation remains volatile with no clear end in sight.

That being said, as market analysts we're keeping an eye on this country-specific exchange-traded fund intended to offer exposure to one of the world's most important economies. Since the initial war headlines, EIS is down about 15%, extending what had been a long-running selloff since the fund's all-time high back in early 2022 amid broader macro volatility.

The key here is that while EIS tracks Israeli stocks, the actual fund exposure is global including several major companies largely operating internationally. The result is that even as Israeli companies are being impacted by the war, the underlying EIS portfolio maintains a layer of diversification that we still believe offers compelling value. Ultimately, EIS deserves some attention as a potential investment opportunity down the line.

What is the EIS ETF?

EIS tracks the "MSCI Israel Capped Investable Market Index" covering large, mid, and -small-cap companies with headquarters in Israel. Keep in mind that many of the stocks have a primary listing in the United States in addition to issuers traded locally on the Tel Aviv Stock Exchange. The fund features a free float-adjusted market cap weighting methodology and is rebalanced quarterly.

Despite the country's relatively small size, Israel has a well-developed capital market with a long tradition of innovation particularly in the technology and the healthcare space. Indeed, the current portfolio of 117 stocks covers representatives across eleven sectors, even more extensive when compared to many other larger country-specific ETFs

We bring this up because it helps to give some context to how Israeli stocks are reacting to the crisis and how different companies may be more impacted than others.

The first point here is that the tech sector represents 34% of the fund. This group includes companies like cybersecurity leaders Check Point Software Technologies Inc ( CHKP ) and CyberArk Software Ltd ( CYBR ) both among the top 10 holdings in EIS together representing about 14% of the entire fund.

Other notable tech names include Wix.com ( WIX ), a provider of website hosting and design solutions. There is also monday.com ltd ( MNDY ), and NICE Ltd ( NICE ) within cloud-based enterprise solutions. While these companies are technically Israeli, we can also consider them multinationals with a broader foreign footprint that drives the bulk of their revenues.

Separate sectors within the Israeli equity market that are global include healthcare, with Teva Pharmaceutical Industries ( TEVA ) as an example. We can also bring up Industrial sector defense stocks like Elbit Systems Ltd ( ESLT ) whose core products, including military electronics systems, are likely in high demand right now.

Beyond disruptions through their local presence within Israel corporate offices, it's fair to say that it is otherwise business as usual in terms of ongoing operations. The crisis is not materially impacting near-term sales and earnings outlook for a large part of the portfolio.

On the other hand, the next sector of exposure within Financial stocks representing 24% of the fund covering local banks is a bit more concerning. In this case, the credit and savings environment in the region is directly impacted by the war, forcing a reassessment in everything from business lending, auto loans, and home mortgages.

We'd expect this sector to face the deepest direct impact of the crisis and it will likely take several quarters to fully understand the repercussions. Notably, Moody's Corp ( MCO ) has placed Israel's sovereign debt rating currently at A1 up for review for a potential downgrade . The report cites the war's potential impact on the government fiscal balance through lower tax revenues reflecting a possibly extended slowdown in the economy.

What's Next for Israeli Stocks?

The main risk to consider when looking at Israeli stocks and the EIS fund is that sectors like financial services, utilities, and real estate have the most exposure to underlying conditions in the domestic economy. Companies that generate the majority of their revenues in the local currency will face the largest swings of volatility.

On this point, the Israeli Shekel has depreciated about 5% this month, although some of that move reflects a stronger U.S. Dollar as a longer-running global theme. The chart below highlights how the ILS to USD exchange rate peaked in late 2021 and is now down about 25% over the period to a near-decade low.

The understanding is that the Israeli economy had already been in a slowdown compared to a post-pandemic boom as a trend consistent with the rest of the global economy. Elevated inflation worldwide as well as rising interest rates in the United States have pressured most foreign currencies in recent years.

We believe FX volatility can accelerate now as a headwind for U.S. dollar-based EIS investors. Still, there is also an understanding that the underlying strength of the Israeli economy with measures that traditionally drive currency fundamentals including an external account surplus and significant FX reserves by the Central Bank should keep the currency moves relatively contained compared to the most speculative emerging markets.

This line of thinking is consistent with Israel's current investment grade credit between Moody's A1 score and Fitch Ratings A+ measure. Even in a scenario of a potential downgrade, we'd expect a single-notch move with all indications that trade flows and economic activity remain somewhat stable in the current circumstances.

From there, our insight into how the war plays out and where it ends will be as much of a guess as anyone else. Between extreme scenarios of an escalating WW3-type conflict or immediate cease-fire, a reasonable base case could be an extended drawn-out conflict where the Israeli economy simply adapts to a new normal of heightened security measures.

As it relates to the EIS ETF, easing tension and less uncertainty is the first step for the fund to sustain a strong rebound. On the upside, Israeli equity investors will also need the global macro picture to cooperate. Recent concerns about a global slowdown and the impact of decade-high interest rates in developed economies including the United States put pressure on investment sentiment. Some evidence that inflation is cooling off and interest rates have a downside would be positive for global risk assets.

Final Thoughts

EIS is a high-quality fund that has been caught up in both market volatility and the consequences of a historic geopolitical conflict. There are significant risks here that can point to further downside and the expectation is for continued volatility for the foreseeable future.

At the same time, there is also a sense that the underlying portfolio is resilient and anchored by a diversified group of companies that are isolated from immediate war impacts. For investors with a long-term perspective, the current volatility can open the door for an attractive entry point through a view that Israel will emerge stronger going forward.

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