Iran-Israel Conflict Recap, Outlook
Tension in the Middle East surged when Iran fired a volley of rockets towards Israel, raising fears of a broader regional conflict.
I Was Enjoying My Coffee Until…
Over the weekend, regional tension in the Middle East surged when Iran launched over 300 drones and missiles directly at Israel. This is the first time Tehran has ever ordered a direct strike against its regional adversary.
99% of all incoming projectiles were intercepted in Israeli airspace and over the country itself. This all came when the Iranian consulate in Syria was struck by a missile in what was likely an Israel-based attack. Senior Commander in the Iranian Revolutionary Guard Corps (IRGC) Mohammad Reza Zahedi was killed.
Iranian officials up to and including Supreme Leader Ayatollah Ali Khamenei subsequently threatened to “slap” Israel for the Syria strike. Saturday’s barrage of missiles and drones was stopped, and Tel Aviv is not willing to turn the other cheek.
Israeli officials have said there would be a “significant response” to the attack. US President Joe Biden spoke privately with Prime Minister Benjamin Netanyahu, urging him to “take the win” to avoid further escalation. Washington has reiterated it stands behind Israel, but will not participate in an offensive endeavor against Iran.
As one Twitter/X user succinctly put it “Now the score is 1:1”. However, when it comes to war, perception is both an offensive and defensive tactic, and a miscalculation could have catastrophic consequences.
From a tactical perspective, Iran is in a tough spot. If it struck too hard, it would have risked prompting Israel to respond in kind or even harder, particularly after the October 7 attack. The perception of vulnerability at this time for Israel, particularly under the current hawkish administration, is unpalatable for Netanyahu’s cabinet.
However, Iran also has to be careful not to act too weak. From a strategic perspective, a lukewarm response would have raise doubts about their fortitude. Looking back historically, Iran's response to actions by Israel, especially those involving the killing of commanders in the Islamic Revolutionary Guard Corps (IRGC), have varied in scale and method.
Its ranged from indirect actions, such as supporting allied groups to carry out operations against Israeli or American interests in the region, to direct military engagements like missile attacks on bases hosting US personnel in Iraq.
Iran's strategy often involves asymmetrical warfare tactics and leveraging its network of proxy forces in countries like Syria, Lebanon, and Yemen to exert pressure and retaliate against its adversaries indirectly. This approach allows Iran to respond to perceived aggressions without engaging in direct conventional military confrontations and risk regional escalation.
This is why Iran’s direct attack on Israel is unprecedented, and therefore in new geopolitical territory with a corresponding level of novel risks. This idea seems to be supported by Iran’s statement that a “new equation” had been opened vis-a-vis Israel. Officials in Tehran have threatened a “much bigger” attack if Tel Aviv responds to Iran’s attack on Saturday.
Impact on Markets
The background concern that a prolonged conflict with other regional proxies funded by Iran could risk dragging the entire country into war. That last scenario is less likely but nevertheless a factor that may be pushing crude oil higher.
Some of these lingering risks may be exerting a hidden influence that’s difficult to quantify. A quintessential example of market sensitivity was when Bolton was fired by the Trump administration. Following his dismissal, oil prices immediately fell close to 4%. This significant market reaction highlighted how investors perceived Bolton as a geopolitical risk. His hawkish stance was seen as potentially destabilizing for Middle Eastern politics, which would have had downstream effects on oil supply.
Some IRGC official made a repeated but empty threat of closing the Strait of Hormuz. Markets have heard this many many times before and so far it’s been a bark with no bite but past performance is not indicative of future results. It remains a threat, but one with a history of no follow through and therefore does not significantly alter the current geopolitical risk outlook.
Defense contracting stocks may pop higher, and oil prices digesting the news over the weekend will likely remain elevated amid the uncertainty. To see more on thematic investing in geopolitical risks, see my Weekly Insight for a few weeks ago: Defense Contracting Stocks: Navigating Thematic Investing & Geopolitics - Part I.
*Not financial advice
Outlook
Biden is urging Netanyahu to exercise restraint. Washington’s focus for a few years now has been China, and a war in the Middle East would divert attention and resources away from a higher priority - and threat. From a macroeconomic perspective, a regional war would also risk reigniting inflation.
This would have several implications:
Elevated oil prices from supply disruptions - or even fear of them - could increase the price at the pump, potentially hurting Mr. Biden’s re-election chances.
Prolonged inflationary trends could disappoint what are already-shifting expectations in rate cuts for this year. A hotter-than-expected CPI print earlier this month has undermined expectations of a reduction in interest rates at the upcoming FOMC meeting from a ~60% chance to ~22%.
Delayed cuts - or even potential hikes - would undermine optimism around loosened credit conditions after an unprecedented hiking cycle. Since the US Dollar is the world’s reserve currency, the impact of Fed policy on global markets more pronounced than any other central bank.
Looking ahead, escalation is not likely, given that it is in no party’s interest to further escalate the situation. Saturday’s attack was in many ways an act of theater for multiple parties to save face. From a strategic perspective, Israel may feel compelled to respond, and there is still some ambiguity as to how and if they will do so.
The chances, however, are quite low.