The recent escalation in hostilities between Israel and Iran has signalled a shift from earlier, more calibrated exchanges to a broader and more sustained confrontation. Analysts at Capital Economics said this phase of the conflict appears far more intense than previous tit-for-tat strikes in April and October 2024, which were “limited in scope and seemed calibrated to avoid a sharp escalation”.

Israel’s strikes, they noted, have now extended beyond Iran’s oil infrastructure to its broader security and domestic systems, including energy networks. “Israel is clearly emboldened by its recent successes against Iranian proxies, Hamas and Hezbollah, and is seeking to remove the threat posed by Iran,” Capital Economics said in commentary on June 16.

Hopes that diplomatic efforts could offer an off-ramp quickly faded. Nuclear talks between the US and Iran scheduled in Oman for June 15 were cancelled, reinforcing expectations that the conflict “could continue for some time”.

Analysts warned that an explicit Israeli shift toward regime change in Iran could further escalate tensions. However, they assessed that the risk of Gulf states being drawn into the conflict remains low, citing their strong ties with Washington and a recent détente with Tehran. Western involvement remains a possibility if Iranian attacks – or miscalculations – target US, French or British interests in the region.

Energy markets are watching closely for any disruption to the Strait of Hormuz, through which around 25% of global seaborne crude and 20% of LNG flows. But Capital Economics said the risk of Iran closing the Strait is “more nuanced than some might suggest”, given Tehran’s own dependence on the route and the potential backlash from key partners like China.

Rather than a total blockade, shipping firms may become increasingly reluctant to transit the Strait, which could “push up insurance premia and tanker rates” or, if sustained, “constrain the supply of oil into the global market”.

For now, oil fundamentals remain largely unchanged. The damage to Iran’s energy infrastructure has been confined to domestic supply. Analysts noted that “the global oil market is set to be well supplied over the next few months”, aided by the OPEC+ pivot towards unwinding voluntary output cuts. The roughly 8% rise in Brent prices has stemmed from a risk premium, not a supply shortage. “The increase in the oil price has purely been due to a rise in the risk premium,” they said.

Neighbouring economies, especially Egypt and Jordan, are likely to suffer more direct economic fallout. In Egypt, Red Sea shipping disruptions have cut Suez Canal traffic by 65% compared to pre-October 2023 levels, contributing to a current account deficit of 6.2% of GDP – the widest since 2017. Jordan has seen a one-third drop in tourist arrivals from outside the region. “With missiles flying directly over Jordan, those security fears will persist,” Capital Economics said.

Israel’s economy, while resilient, will face near-term strain. “There will still be a negative shock as residents remain indoors, and both households and businesses postpone spending decisions,” the analysts noted. The aerial nature of the conflict means labour market disruption is limited, and most lost output may be recouped if fighting ends within weeks. Still, sectors like tourism are expected to experience more lasting damage.

Higher military spending will add to fiscal pressure, with Israel already running a budget deficit of around 5% of GDP. Although manageable in the near term due to low borrowing costs, Capital Economics cautioned that the long-term outlook hinges on the trajectory of the conflict: “Does it remove the threat and allow Israel to dial back military spending, or does Israel require a permanently larger military footprint?”

Finally, the outlook for the Abraham Accords remains unclear. While some hoped a weakened Iran might pave the way for Saudi Arabia to normalise relations with Israel, Riyadh has reiterated its demands for an end to the Gaza occupation and a two-state solution.