When Israelis vote for a new prime minister on February 6 investors overwhelmingly will be hoping for a win by Ehud Barak, the candidate seen as more likely to make peace with Palestinians.
But the increasing likelihood that right-winger Ariel Sharon will trounce the prime minister in the election is putting pressure on Israeli share prices and leading to a flow of foreign investment out of the Tel Aviv market.
"The bottom line is people are worried about Sharon. Foreigners especially are worried about his history, the Lebanon war; his reputation is not that of a peace lover," said Ehud Helft, Israel analyst for Credit Suisse First Boston.
Israel was the best performing emerging market last year, based on Morgan Stanley indices, although much of this was due to Nasdaq-traded Check Point Software Technologies.
But even the Tel Aviv Stock Exchange general index eked out a tiny gain in dollar terms, compared with a 32 percent drop for emerging markets as a whole.
Yet Merrill Lynch last week downgraded Israel to underweight from neutral, citing the potential for politics to depress market sentiment.
"We are concerned that politics could have a negative impact, with a strong possibility of Ariel Sharon winning the prime ministerial vote," Merrill Lynch said in a report.
Helft said CSFB downgraded Israel to 20 percent underweight from neutral in October, just after the outbreak of a Palestinian uprising. At least 313 Palestinians, 49 Israelis and 13 Israeli Arabs have been killed in the violence.
TEL AVIV MARKET DOWN 10 PERCENT
Since the start of 2001 the Tel Aviv market has fallen 10 percent and is likely to continue to drop, at least until the election.
Noting the likelihood that Sharon will win, Merrill Lynch said: "This has the potential further to inflame passions in the Middle East, since there are few figures as divisive as Mr Sharon."
Sharon, who led Israel's 1982 invasion of Lebanon, is far ahead of Barak in pre-election opinion polls. Palestinians accuse Sharon of sparking clashes in the West Bank and Gaza Strip by visiting on September 28 a Jerusalem shrine holy to both Muslims and Jews. He denies he is to blame.
"The candidate viewed as being more 'pro peace process' is viewed more favourably by the market and in this case that is Ehud Barak," said Lehman Brothers analyst Richard Gussow.
"Having said that, there is a bit of scepticism that an agreement can be reached under anyone."
He noted that net foreign sales of Tel Aviv shares by foreigners in October totalled $160 million and in the first 11 months of 2000 reached $405 million.
The selling intensified towards the end of the year and preliminary figures for December show net sales of $120 million, Gussow said, adding that net sales were also likely in January.
MARKET SEEKS STABLE COALITION
Following the election, the market will take its direction from the coalition formed by the winner. But the "Sharon effect" appears pretty much to have run its course.
"Sharon is already priced into the market," Helft said. "The market will want to see what the new prime minister will do, what his coalition will be. That will be key."
Israeli economist Jonathan Katz said what the market wants more than anything is a broad, stable coalition.
"The markets don't want a weak slim coalition, with all the horse trading and with religious parties trying to push their transfer payments higher," Katz said. "The ideal would be a unity government with (Sharon's) Likud and (Barak's) Labour together."
The new government will be tested quickly, with Israeli law requiring that it pass a 2001 budget by the end of March or call for a general election. Barak's battered government failed to pass a budget for this year.
Analysts say that based on the past decade, there is little difference between the two main parties when it comes to economic policy.
Yet Sharon's history in previous cabinet positions has earned him the reputation of a big spender, and this concerns investors.
"In every position he pursued the interest of that ministry. He built like crazy when the wave of immigrants came (in the early 1990s) and exceeded the budget," Katz said. "But that means nothing as prime minister."
While Barak as prime minister did not devote much time to the economy, he did allow the Finance Ministry to exercise fiscal discipline and he supported the central bank's cautious monetary programme.
But even if Sharon wins, foreign investment banks say their downgrading of Israeli's market could be short-lived, especially if macroeconomic fundamentals start to pick up.
"Depending on what policies are in place, we would look to upgrade the rating," Helft said.