JERUSALEM/LONDON Political stability and receding worries about an attack on Iran are likely to support Israel's markets after the country formed a unity government on Tuesday, but budget and regulatory reform could be a worry.
Prime Minister Benjamin Netanyahu formed the broad coalition government in a political surprise that avoided an early election.
By bringing in the centrist Kadima party led by former defense chief Shaul Mofaz, Netanyahu, who heads the right-wing Likud, will have a government controlling 94 of parliament's 120 seats.
"There's a mild positive sentiment," said Zach Herzog, head of international sales at the Psagot brokerage in Tel Aviv, noting, however, there may be some extra spending ahead.
"By and large we're getting additional political stability but perhaps it's going to come at the cost of some anti-market forces rearing their heads," Herzog said.
In response to a public outcry over the high cost of living and an economy dominated by just a few large groups, the government has planned reforms over competition that would force conglomerates to divest some of their assets, and significant telecoms sector changes that would create a wholesale market.
The new political deal that would keep the next election in October 2013 also has investors worried over fiscal policy. Weaker tax income due to slowing economic growth and higher social spending will already push the 2012 budget deficit to at least 3.4 of gross domestic product -- well above a target of 2 percent.
"I don't see Netanyahu saying that this is the time to be tightening the belt," Herzog said.
Some analysts were more optimistic, however.
"We think that the government, with help of Kadima, will vote to lower the budget deficit," said Luis Costa, emerging markets strategist at Citi, in a client note.
Government bond prices were marginally higher following the news, though the shekel barely budged against the dollar and Tel Aviv share indexes were largely flat.
The unity government could give Netanyahu a freer hand to attack Iran's nuclear facilities but most analysts see the chances of a strike diminishing.
The shekel and stock market came under pressure earlier this year -- at a time when many other markets were performing strongly -- as many investors worried about the geopolitical implications of such an attack.
But those fears have already faded.
"People are a lot less worried," said David Lubin, head of CEEMEA research at Citi.
"You can see in the fall in the oil price that the geopolitical risk premium has lessened in the last couple of months, the aggressive rhetoric that had been coming from (Defence Minister) Barak and Netanyahu in January and February has slightly disappeared."
As deputy prime minister in a former Kadima-headed government in 2008, Iranian-born Mofaz was among the first Israeli officials to publicly moot the possibility of an attack on Iran. But he has been more circumspect while in the opposition.
Dissenting voices in Israel have further lessened the chances of a strike, analysts say, after recent remarks by recently retired security chiefs and the current military commander questioning Barak and Netanyahu's stance.
That makes Israel a more attractive location for investment.
Dublin-based online exchange Intrade.com put the chances of an attack on Iran by the U.S. and/or Israel by the end of the third quarter at only 20 percent on Tuesday, compared with more than 40 percent two months ago. The exchange's predictions are monitored by analysts and investors.
(Additional reporting by Clare Kane in London. Editing by Jeremy Gaunt.)