An update on the Middle East

On-the-ground perspective

The conflict in the Middle East has intensified significantly as Israel ramps up its military campaign, opening multiple fronts. After days of heavy aerial bombardments across Lebanon, Israeli ground forces have now advanced into southern Lebanon, marking a significant escalation in the conflict. Simultaneously, Israeli airstrikes have resumed their assault on the suburbs of Beirut, targeting areas known as Hezbollah strongholds. Adding to the turmoil, Iran’s missile barrage on Israel has introduced a new layer of volatility to an already unstable situation. The swift pace of these developments is making it increasingly challenging to keep up with the evolving dynamics on the ground.

Despite these intense developments, a full-scale interstate war between Israel and Iran remains unlikely in the short term. Israel, however, will likely continue to adopt an increasingly aggressive stance toward its regional adversaries, particularly Hezbollah, aiming for a decisive confrontation while managing limited engagement with Iran.

Escalating tensions in the Middle East

The escalating tensions in the Middle East have negatively impacted equity markets in the region and the global crude oil markets. Gold, US Treasuries and select Gulf Cooperation Council (GCC) bonds have attracted investor attention given their perceived safe-haven status.

Iran's recent missile attack on Israel led to a brief spike in oil prices, reviving a war premium as fears of disruptions to vital oil flows grow. This region accounts for 40% of the world's seaborne oil trade. The Strait of Hormuz alone is responsible for 28%, serving as a critical chokepoint, especially for Saudi Arabian exports to Asia. While Israeli officials have vowed retaliation, increasing the risk of a tit-for-tat escalation, the market has not yet fully priced in the potential for further attacks on Iranian oil facilities or a blockade of the Strait—an action Tehran has threatened in the past. The focus now shifts to Israel's next move; though the risk of significant supply disruptions remains low, in our view, it is rising.

GCC equity markets have shown signs of underperformance relative to global equities, reflecting investor concerns over rising geopolitical tensions. GCC bond markets, on the other hand, have been resilient with positive performance on the back of lower US Treasury yields.

International participation in both markets continues, indicating that investors view the conflict as localized rather than a full-scale regional crisis. Ongoing initial public offering activities in the GCC further suggest to us that the risk of broader escalation is not yet factored in. GCC stock markets have generally remained resilient amid the conflict between Israel and its neighbors. We note Iran's missile strikes against Israel in April did not have a lasting market impact.

Unless the conflict expands to include GCC countries like Saudi Arabia or the UAE, most market observers expect the financial market impact to remain limited. Nevertheless, the intensifying situation adds uncertainty to other key geopolitical issues and warrants investment caution, with a focus on higher quality companies and issuers.

Israel’s military strategy and focus on Hezbollah

Israel's ongoing offensives in Gaza and Lebanon are unlikely to be deterred by Iran's recent missile strike, even though tensions have escalated. The significant degradation of Hezbollah's military capabilities has considerably weakened the group. Israel aims to capitalize on this disarray to neutralize Hezbollah as a strategic threat in the region. Airstrikes are expected to continue deep into Lebanese territory, including central Beirut, and the ground offensive in southern Lebanon underscores Israel's commitment to further diminishing Hezbollah's capabilities. The military strategy focuses on forcing Hezbollah into a retreat by employing superior firepower and disrupting command and control structures. Continued presence or occupation of Lebanese territory could reinvigorate resistance efforts in Lebanon.

Iran's calculations and internal dynamics

Iran finds itself in a delicate position. The recent missile barrage, particularly with the use of faster rockets that pierced Israel's air defense systems, appears to be a calculated move to appease hardliners within Iran and reassure its regional proxies like Hezbollah of its continued commitment. However, Iran's actions remain limited in scope and focused on military targets and are likely to avoid crossing a threshold that would prompt a larger military response from Israel or the United States.

Israel's potential responses to Iran

Israeli leaders have declared that retaliation against Iran is inevitable, focusing global attention on their next move. As we see it, Israel has three primary options:

1. Target Iran's military infrastructure: Aligns with US preferences and the most immediate course of action. Striking military assets used in attacks against Israel can be justified as a direct response to Iranian aggression.
2. Strike Iran's nuclear program: A longstanding priority for Prime Minister Benjamin Netanyahu, though it carries significant risks of escalation. Targeting uranium enrichment facilities and weaponization-related sites would address Israel's concerns about Iran's nuclear capabilities but could provoke a severe response in return.
3. Attack Iran's oil production and exports: The least likely option due to the potential for massive Iranian retaliation and the risk of alienating international partners, including the United States, European Union and Gulf states. Disrupting Iran's oil infrastructure could have widespread economic implications and escalate the conflict beyond control.

The United States has reiterated its support for Israel's defense but has shown no inclination to endorse an offensive against Iran. Moreover, the views of neighboring countries such as Iraq and Syria, which are openly hostile to Israel, and Saudi Arabia and Turkey, which are reluctant to support Israeli military action, further diminish the feasibility of a full-scale Israeli campaign against Iran.

As long as the current conflict does not expand to include Saudi Arabia or the United Arab Emirates, the financial market impact of the conflict should remain contained, in our view. Nevertheless, the intensifying situation adds uncertainty and warrants caution. Our focus remains on higher-quality companies and issuers.