Geopolitical risks ease, but economic challenges persist
Cautious optimism but macro risks remain high: Israel's geopolitical risk profile has significantly decreased toward the start of 2025. The ceasefire in Lebanon is holding, Iran’s regional influence has weakened following the collapse of the Assad regime, and Israel and Hamas have reached a ceasefire and hostage deal in the south. These developments have helped reduce fiscal and credit risks. Israel's risk premium, as measured by 10-year CDS spreads, has dropped to about 112 basis points, from a peak of 190 and around 75 before the war. Long-term bond yields have also declined, from 5% to 4.5%, with the yield gap against U.S. Treasuries nearly closing.
However, Israel's overall risk level remains elevated. Uncertainty persists regarding the successful implementation of the Hamas agreement, particularly the transition to its second phase. Additionally, the potential for escalation with Iran over its nuclear ambitions remains a key concern. Domestic political complexities and ongoing tensions over judicial independence further contribute to a high degree of uncertainty in Israel’s risk outlook.
Real economy: Israel’s economic conditions at the end of 2024 reflect a moderate recovery, though output remains below pre-war levels. Recent indicators for December show a rebound following the ceasefire agreements, prompting an upward revision of Q4 growth estimates. However, GDP per capita for 2024 is expected to decline by 1.0%. Our macro forecasts for 2025 and 2026 are based on two main scenarios: a "continued conflict" scenario and a "ceasefire and stabilization" scenario. At present, the latter appears more probable. Under this scenario, GDP growth in 2025 is projected to reach 4.6%, alongside a reduction in fiscal deficit within 4.5%-5%. We assume that supply-side constraints will gradually ease over the forecast period, while domestic demand is expected to recover. However, despite the acceleration in growth, it is expected to remain relatively moderate due to rising taxes and government-controlled prices, which constrain the potential expansion of private consumption.
Monetary outlook: December 2024’s CPI print of -0.3% came in below expectations, continuing the trend from November and October. The year ended with a 3.2% year-over-year increase, slightly over the upper limit of the target range. However, annual inflation is expected to have risen to 3.7% in January due to tax hikes, primarily the VAT increase, as well as higher prices for regulated goods and services such as electricity, water, and property taxes. Inflation is projected to remain above 3% throughout the first half of the year.
Markets have absorbed the recent lower inflation readings, leading to a downward revision in one-year inflation expectations to just 2.4%. However, inflationary pressures persist, due to a tight labor market, rising wages, a high fiscal deficit, and geopolitical instability. As a result, we do not anticipate a monetary rate cut at the Bank of Israel's next meeting on February 26 or during the first half of the year. In the second half, inflation is expected to gradually decline toward 3%, allowing the central bank to implement two rate cuts during that period.
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