The politics of the Middle East lie heavy in the air around the Israeli markets following last month's peace accord. After the calm of the first three quarters of the year, there is uncertainty among investors, although there seem few macroeconomic reasons for this.

Stephen Levy, analyst at UBS-WDR in Tel Aviv, feels that we may be coming to the end of at least part of the problem. Although the balance of payments and exchange rate are within acceptable parameters, speculation in the currency has worried people, and this has seriously affected the equity markets. Also the fact that the governor of the Bank of Israel is a monetary hawk, and has responded to what is essentially a mini currency crisis - though important in Israeli terms - with quick-fire interest rate hikes."

His colleague Mansoor Mohi-Uddin in the London office agrees, and expresses surprise that the second of November's rate increases took place in-between the normal monthly meetings of the bank's managing committee. "In the past the central bank has modelled itself on western counterparts, and allowed the market to dictate interest rates."

Having assumed that the shekel-dollar rate would retrace last month, a rise to around 4.50 was anticipated. Now its fate seems to depend on US policy, but Mohi- Uddin believes that it must hold above 4.15. "If it does not fall too far then I think we will expect to see it stable above that mark in the near future," he says.

Currency speculation, and the Bank of Israel's response to it has inevitably had an impact on the stock exchange, where trading towards the end of the year has been slow. With interest rates at 6% or above, local investors especially have left the equity market and moved into bonds.

Nevertheless Levy sees some positive sectors. "The chemicals and high-tech industries should be in good shape, since they export around 90% of their products, and their costs are based in local currency. However, even here there are problems. Chemicals have been hit by the worldwide downturn in demand, and playing the high-tech market is dangerous because of the uncertainty in the US markets." Pharmaceuticals is another positive industry, with few perceived imminent difficulties.

The same cannot be said for the banks. With some $30bn of foreign exchange loans out to domestic companies, the effective devaluation has meant many companies are failing on their repayments. The likelihood is that banks will have to make extra provision for this, and given the importance of the sector to the index, this could result in a knock-on effect, thinks Levy. The construction industry in particular could be hit because of the loans issue.

Rony Argi, senior Israeli analyst at HSBC Securities, points out that the Israeli banking sector is disproportionately exposed to loans in construction and real estate. "There are already pressures in these sectors due to a fall in demand and the exchange rate, and most banks are going to have to reduce costs to maintain profitability. The decreasing provisions which have been a feature of Israeli banks for the past three years are definitely a thing of the past," he added.

Argi feels that next year will see a neutral or possibly negative market. The three reasons he earmarks are the outlooks for earnings, interest rates and demand. "Given the slowdown in the economy, earnings growth is likely to be very limited. Internal demand and investment will continue to slow, and expect only a small increase in GDP." On interest rates he warns that we may not have seen the last rise.

"Finally on the question of demand, we have seen foreign investors, who have been driving the exchange, selling and quitting the market. It is unlikely that they will hurry back. As far as domestic demand is concerned, most Israelis are wondering which currency they should be holding, and many would rather hang on to dollars rather than invest in stock," he says.

There remains the question of whether current policies are actually working. The Central Bank's target of 4% inflation for next year is beginning to look laughable, with last November alone threatening that figure. A major problem is that, with housing priced in US dollars, any currency movement is fuelling the inflation figure.

Further uncertainty sadly seems likely to follow the recent peace talks, with political unrest and possible violence further depressing the markets. As so often has been the case in the past, political rather than economic influences may be the major factors affecting investors in 1999. Kevin Hall"

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