MORGAN:

Last month we witnessed a series of shocks and escalations in the Middle East, and tensions are only increasing. How have these developments changed the post-October 7 conflict in the Middle East?

COHEN:

A wider war has been possible since the beginning. In particular, a war between Israel and Hezbollah has been possible since October 8, when Hezbollah fired its first rockets after Hamas's attack. More than 80,000 Israelis have evacuated their homes in northern Israel since, and most remain displaced. The killing of 12 Druze children playing on a soccer field on July 27 made a larger war between the two sides much more likely.

An all-out war with Hezbollah could be more violent, for both Lebanon and Israel, than the conflict with Hamas has been to date. Hezbollah has an arsenal of 120,000 to 200,000 rockets and missiles, including hundreds of precision guided missiles and 65,000 short-range rockets. These munitions could strike cities throughout Israel, as well critical infrastructure, such as electricity grids.

Israel has also reshaped the war in the last few weeks. Despite ten months of conflict, Israel's longest since its War of Independence from 1948 – 1949, the Israel Defense Forces and intelligence services have shown themselves to still be tremendously capable. In retaliation for the Houthi drone attack on Tel Aviv, Israel's air force struck the Houthi-controlled Hudaydah port in faraway Yemen, refueling mid-air during the long-distance mission. The bomb that killed Hamas leader Ismail Haniyeh was reportedly planted in an Iranian Revolutionary Guard Corps (IRGC) guesthouse months ago. This was a shock for the Supreme Leader, who is aging and now never leaves the country. Combined with the elimination of Hamas leader Mohammed Deif and Hezbollah military commander Fuad Shukr, who played a role in the 1983 Marine Corps Barracks bombing in Beirut, and other targeted assassinations, Israel may be trying to retake the initiative and show Iran the unexpected and high costs of escalation.

MORGAN:

Many observers are expecting retaliation by Iran, possibly including a direct assault against Israel. Is such an attack likely, and are Israel, the US and their partners prepared for such an escalation?

COHEN:

We don't know the timing of a potential Iranian retaliation, and it's impossible to predict the scale with certainty. But a direct Iranian-led assault against Israel looks increasingly likely, and Israelis and their partners are preparing.

This is a very precarious moment for the region, and the risks are high. In April, Iran broke the geopolitical seal on direct confrontation, when it fired 170 drones, more than 30 cruise missiles, and more than 120 ballistic missiles against Israel. Israel reportedly struck back. After the killing of Haniyeh, on August 1 in Tehran, Supreme Leader Ayatollah Ali Khamenei met in Tehran with proxy groups from Iraq, Syria, and Lebanon to discuss retaliation against Israel.

What could make this potential attack different from April's? There is an increased level of coordination among Iran and its proxies across seven fronts. In addition, it's possible that Iran could use more munitions, attack different targets, and engage in prolonged assaults that could overwhelm Israel's defense systems, or even use its proxies to simultaneously attack US forces in Syria or Iraq, where several servicemembers were injured earlier this week. Iran or its proxies could also attack Israel or Jewish targets abroad, such when Hezbollah attacked a Jewish community center in Argentina in 1994 or attempted to execute a plot in Brazil at the beginning of the current war. And the closer we get to the US election, the more uncertainty there will likely be about US politics and engagement in the region.

The preparations to defend against Iranian attacks are extensive. Israel and its partners intercepted almost all Iran's missiles and drones four months ago, and Jerusalem and its allies and partners are working together again. Countries are urging their citizens to leave Lebanon. The US and Arab countries have in recent days sent envoys and messages to Tehran to work to deescalate the situation, so far without success. The commander of US Central Command arrived in Israel earlier this week. The US is moving more defensive assets to the region, including the USS Abraham Lincoln aircraft carrier strike group, which will replace the USS Theodore Roosevelt. Israel is likely closely coordinating with its Sunni Arab neighbors – what Prime Minister Netanyahu now refers to as the "Abraham Alliance" – to defend against their shared rival in Iran. And, depending on the scale of the attack, Israeli Defense Minister Yoav Gallant has said the military is ready for a "swift transition to offense."

MORGAN:

How do the events of the last month fit into Iran's broader regional strategy, and do you expect any change in Iran's calculus?

COHEN:

In my view, Iran relies on proxies to achieve its objectives to attack Israel, push the US out of Iraq and Syria, and become the dominant power in the Middle East. Those objectives likely have not changed. But, as April's Iranian attack against Israel showed, Tehran is now more prepared than it was before to engage in direct confrontation, rather than relying exclusively on proxies and covert action. If Iran directly attacks Israel, the US, or their allies and partners in the next few days or weeks, we will be able to better calculate if Tehran is seeking a wider, all-out regional war, with all the costs that would bring, or if its strategy is to save face and continue the conflict at its current levels. An attack is increasingly likely, but as Israel's actions over the last few weeks have shown, escalation presents enormous risks to the regime in Iran as well.

MORGAN:

How do you think about the broader geopolitical setup in the Middle East and the incentives and positioning of each of the key regional actors?

COHEN:

There have been two key strategic questions since October 7. First, can Iran and its proxies create a new normal in the Middle East, with constant conflict and attrition that wears down Israel, the US and their allies and partners, without imposing unacceptable direct costs on Tehran? And second, can they break apart an emerging Israel-Sunni Arab bloc and become the dominant power in the region?

On the former, Iran has so far succeeded. The damage that Iran and its proxies have done to Israel, Palestinians, and populations throughout the region is enormous. The costs to Iran – including attacks on Iranian soil and the targeting of IRGC commanders – have so far not been high enough to change Tehran's overall strategy.

But Iran has not yet succeeded in breaking apart the Israel-Sunni bloc. We saw that in April, when Israel coordinated its defense with countries like Saudi Arabia and Jordan. The Abraham Accords between Israel and the United Arab Emirates, Bahrain, Morocco, and even Sudan continue to hold. The incentives for this bloc – as diverse as the actors are – to not let Iran dominate the Middle East are clear. And if anything, this geopolitical test has reinforced the direction of travel for wealthy Gulf countries, who have been pushing for economic integration and diversification and for greater influence on the global stage. To succeed, however, Israel and Washington's partners in the Gulf will likely need US support.

COHEN:

How have markets reacted to the rise in geopolitical tensions?

MORGAN:

There has been a significant re-pricing of regional assets (e.g. Israel CDS, USDILS FX, ILS interest rate swaps) since mid-July, but the impact on commodities has been limited (and the oil price is down on the month). Equity markets (SPX in particular, but notably Nasdaq and Topix as well) and bond markets (such as short dated UST) have re-priced meaningfully in recent weeks, and Middle Eastern escalations have contributed to a sense of market nervousness, but the primary drivers of market moves have been a changing market perception around US recession risk, US tech earnings reports, questions about the timing and magnitude of the impact of developments in Gen(AI), and de-risking of crowded trades.

COHEN:

If the market reactions to the events in the Middle East have (so far) been limited, what escalations in the region could shift how the markets view the current crisis and its effects on global growth? What lessons have we learned that could be useful for future geopolitical shocks?

MORGAN:

The primary market nexus through which Middle Eastern tensions could have global growth impact would be via the oil market (as was the case in the 1970s). To date, the oil market has largely shrugged off geopolitical concerns and focused on the impact on demand of US and China slowdowns (and the potential impact of the US election on supply). A further escalation could impact oil markets to the upside if critical oil infrastructure were endangered. The broader lesson remains that the markets focus first and foremost on the economy and policy. Geopolitical tensions have major impacts on specific companies, sectors (e.g. defense), and countries, but for global impacts there needs to be a direct knock-on to growth, inflation (e.g. via oil prices), or monetary and fiscal policy. The focus for now will remain on the US economy and areas of potential concern (such as low-end consumers, and housing), the extent of the Fed' put' and their willingness to ease rates fast (e.g. the possibility of 50bp increment cuts), and big tech AI expenditure and earnings.