Events in Israel and Gaza are first and foremost a human tragedy. In this note we share our initial thoughts on the geo-military scenarios and macroeconomic implications, while trying to remain aware of the sensitives around these terrible events. We see four main geo-military scenarios from here.
Potential geo-military scenarios
1. Contained ground invasion of Gaza
Our base case is that Israel launches a ground operation aimed at removing Hamas and recovering hostages. Israeli troops are massing in significant size along the border, and the Israeli government signaling clearly points in this direction. In this base case the conflict is contained to Gaza. Early signals suggest that Hezbollah and Iran, Hamas' main regional allies, are unwilling to become directly involved in the conflict. The US is also working with regional allies to prevent an escalation of the conflict, including sending two carrier groups to the eastern Mediterranean.
Due to the scale of Hamas' attack on Israel, is it unlikely that it will be politically acceptable for any ground operation into Gaza to end with Hamas still in control of the territory. Depending on the success of Israeli military operations – urban warfare is notoriously difficult – it is possible that the current conflict could continue for many months.
2. Escalation to other Iran-backed actors
A ground offensive will increase the risks of Hamas' allies, particularly Hezbollah, joining the conflict.
Another factor increasing escalatory risks is the political pressure on Prime Minister Netanyahu to demonstrate the strength of the Israeli military and security apparatus. The events of last month represent a massive intelligence failure. Indeed, as, and when the immediate crisis ends, Netanyahu will face serious questions over his leadership. One path to avoiding this will be to demonstrate that after the initial mistake, Israel can comprehensively achieve long-standing security goals.
We therefore put a reasonably high probability on an escalatory scenario in which efforts to contain the conflict fail and other Iran-backed actors, most likely Hezbollah, enter the conflict. Israel might respond with strikes on the infrastructure of Iran-backed actors inside Lebanon and Syria.
Israel would be left fighting on two fronts – in Gaza and on the Israel-Lebanon border, with the Golan Heights also a potential conflict zone. Israel has already acknowledged the risks of this occurring, having ordered the evacuation of a one-mile zone on the border with Lebanon.
3. Full-scale Middle East war
Despite ongoing diplomatic efforts on all sides to avoid a significant deterioration in the region, there remains a small chance that the ground invasion of Gaza triggers a broader destabilization of the Middle East as multiple actors, including Iran, are pulled into an active conflict.
This scenario could begin with credible evidence emerging that Hamas had assistance from Iran in planning and facilitating the attack on Israel. This could lead to Israeli military strikes on Iran and more international sanctions. Operating on multiple fronts would slow Israel's military progress, leading to a longer offensive in Gaza. Hamas and its allies could accuse Israel of a de-facto occupation, further inflaming tensions. The humanitarian crisis would deepen, with large population movements likely, further destabilizing neighboring countries as they attempt to cope with the political and economic fallout.
There is no official evidence at this stage to suggest direct Iranian involvement in Hamas' attack on Israel, and multiple diplomatic safeguards would have to be breached for a broader war, limiting the likelihood of this downside scenario.
4. Conflict de-escalates
Finally, there is at least some chance that the situation deescalates without a ground invasion. US efforts at securing safe routes for civilian evacuation out of Gaza into Egypt, and for aid to flow into Gaza, could potentially give way to a more lasting ceasefire. Diplomatic outcry at the humanitarian crisis in Gaza would be an important waymark to this scenario, but internal political dynamics in Israel would militate against it. On balance, de-escalation seems unlikely at this stage.
Implications for the war in Ukraine
NATO has given Ukraine assurances that its support for Israel will not affect its ability to provide ongoing military support to Ukraine. However, a drawn-out effort to remove Hamas, or escalation in the scope of the conflict, would risk attention being diverted away from Ukraine, as well as military aid being divided between the two countries. The biggest risk for Ukraine is that it simply falls down its allies' priority list, with less time and money being spent on meeting its requests.
The impact of US political divisions
US domestic political divisions are also having an impact. Without a speaker in the House of Representatives, Congress is unable to pass new aid for Ukraine or Israel, with the US government instead relying on existing funding and diplomatic efforts to provide limited support.
Additionally, an ongoing block on approval of military promotions by Senator Tommy Tuberville has left the US without staff members in key positions. The US also does not have an ambassador to Israel at this time. In many instances roles are being undertaken by acting appointees who lack full legal powers. This by no means prevents the US from providing support to Israel but makes coordinating actions more difficult.
Increased geo-political risk premium
We see two primary transmission channels to the global economy. The first is through an increase in geopolitical uncertainty in general, which gets reflected in higher risk premia on asset prices and lower business and consumer confidence.
So far, standard news-based measures of geo-political uncertainty have moved higher but remain below Ukraine invasion highs (Chart 1). The VIX has moved by less and remains in relatively untroubled territory. However, if some of the escalatory scenarios we sketched out were to occur, the index could increase much more substantially.
Chart 1. Measures of geopolitical uncertainty have moved higher, although the VIX remains untroubled
Source: abrdn, Haver, October 2023.
Direct and indirect energy market impacts
The second channel is through a reduction in energy commodity supply and higher prices, with its attendant spillovers to global inflation and growth. So far, this impact has been relatively small (Chart 2).
Chart 2. So far at least, the energy price rise pales in comparison to the Russia-Ukraine shock
Source: abrdn, Haver, October 2023.
Israel has become an exporter of natural gas in recent years. The shutdown of the major Chevron-run Tamar gas field due to safety concern constricts supply at a time when firms are still seeking alternatives to Russian pipeline flows, the Baltic Connector between Finland and Estonia is out of action and the European winter is approaching.
The conflict has also raised questions around the Saudi and Iranian oil supply to global markets. The prospect of a normalization in Israel-Saudi relations was expected to trigger an increase in Saudi oil supply as an informal quid pro quo of the US-brokered deal. These efforts at normalization are likely now on indefinite pause, reducing expected future oil supply.
Meanwhile, the policing of Iranian oil sanctions is likely to be more stringent. The US had appeared to be turning a blind eye to sanctioned Iranian oil supply finding its way onto global markets amid inflation concerns. However, this could end, especially if credible evidence of Iranian involvement or foreknowledge of the Hamas attack emerges.
In the more severe escalatory scenarios that we have outlined, global oil supplies may be much more severely impacted. Admittedly OPEC spare capacity is probably sufficient to cover the loss of 1.4 million bpd of Iranian exports should Iran be forced to shut down capacity. But, in contrast to October 1973 – the last time Israel experienced an intelligence failure on this scale – other oil producers are unlikely to cut crude supplies to punish Israel’s international allies.
There would however be a wider risk to the roughly 20% of global flows that pass through the Strait of Hormuz, which would be at risk from Iranian attack. In this severe downside scenario, it might be possible for oil prices to approach the real-terms highs of past oil price shocks, with a peak above $140 per barrel plausible (Chart 3).
Chart 3. Conflicts in the Middle East can have varying scale of (real) oil price impacts
Source: abrdn, Haver, October 2023.
Needless to say, global inflation could rise significantly, and growth would be hit.
Rough rules-of-thumb would suggest that the approximately 50% oil price move we have penciled in for the worst-case scenario would knock off 1% of GDP for oil importers (note that the US is a net oil exporter). Meanwhile, a move of this magnitude would add roughly 2% to headline inflation in most economies.