Background
On 13 June, a day before Washington and Tehran were set to hold negotiations in Oman over Iran’s nuclear program, Israel launched operation “Rising Lion”, targeting military and nuclear facilities in Iran with missile attacks. Since then, Israel and Iran have attacked each other on a daily basis, with Israel taking the upper hand due to its superior military capabilities and intelligence operations.
Despite President Trump claiming late last week that he would give Iran two weeks to come to the negotiating table and make concessions before the US would get involved, the US launched a surprise attack over the weekend on Iran’s three main nuclear sites at Fordo, Natanz and Isfahan. The US used its bunker busting GBU-57 Massive Ordnance Penetrator (MOP) bombs due to the fact that the Fordo site is buried deep underground and protected by thick concrete. These MOP bombs are the only bombs in the world capable of penetrating sufficiently deeply to get to the Fordo facilities, so it was essential from Israel’s perspective that the US became involved.
In a show of strength and in addition to the MOP bombing raid, the US has sent two aircraft carriers to the region, with a third on the way. The presence of the aircraft carriers will increase US capabilities in the region should further action be needed and also serve as a cautionary reminder of US military might. No doubt the US administration and military strategists will be hoping that this will help deter significant retaliation from Iran or its proxies and encourage a negotiated solution.
China and Russia have remained remarkably quiet regarding recent events in the Middle East. Both Xi and Putin have called for de-escalation, but more material support for Iran beyond this has not been forthcoming. This is perhaps surprising given Iran has reportedly provided Russia with drones to aid in its war in Ukraine.
There are many moving parts to the conflict and hence there are many possible paths that could be followed. Nonetheless, it is useful to provide a scenario analysis that intentionally simplifies that situation and provides a helpful guide to potential outcomes. The analysis below summarises our main views and the potential implications for the main asset classes. Whilst a sense of nervousness is understandable, it is noteworthy that previous episodes of heightened geopolitical risk have often had only a limited and brief market impact, something that is reflected in our analysis.
Scenario 1 – Ongoing Israeli bombardment, very limited further direct US involvement – 65%
Overview
In this scenario, further US involvement is avoided, other than continuing to supply Israel with military equipment and maintaining a significant presence in the region to act as a deterrent. There may be occasional US military responses but the Trump administration is keen to avoid anything that commits US troops or ongoing direct military engagement. Israel continues the aerial bombardment of Iran, aiming to degrade further Iran’s military capabilities and nuclear aspirations.
Previous examples of similar situations include Israel’s airstrikes in Iraq in April 1981 and in Syria in September 2007, both of which caused significant disruptions and setback the nuclear weapons programs of Sadam Hussein and Bashar al-Assad respectively.
Given by how much Iran’s air defences already appear to be destroyed, our expectation in this scenario is that Israel can achieve its main objectives in a matter of weeks or a few months at most. Once achieved, Israel can then largely cease its bombardment, something that may coincide with some sort of uncomfortable truce, whether officially negotiated or simply unofficially agreed via diplomatic back channels.
As part of this scenario, there may be some retaliatory strikes from Iran on some US assets as a means to placate its domestic audience although the impact is minimal and does not significantly influence the situation. Such attacks would likely be symbolic in nature and would be aimed at saving face domestically whilst hoping to avoid provoking the US into a large response. However, there is a prolonged increased risk of global terrorist attacks.
Scenario 2 – Iranian retaliation and escalation – 25%
Overview
It is possible that, despite being overwhelmed by Israeli and US military superiority, Iran has kept some resources in reserve that it then uses to stage counter attacks. Iran may, for example, have moved some nuclear materials and equipment to other unknown sites that allow it to restart its nuclear program. This is then accelerated as a defensive strategy. This may occur at the same time as the Iranian population is unified and outraged by the attacks, encouraging the Iranian authorities to pursue a more aggressive military stance.
Another potential strategy that would cause the situation to escalate and deteriorate is closing the Strait of Hormuz or at least making it very difficult for tankers and other ships to pass through it for fear of being attacked by Iran or one of its proxies such as the Houthi rebels. Attacks on US bases in the region are more serious in this scenario, forcing the US to be sucked into a more prolonged and committed involvement in the war than many in the Make America Great Again (MAGA) base think appropriate.
Scenario 3 – Iranian capitulation: a return to diplomacy – 10%
Overview
The best possible outcome would see the Iranian authorities capitulate, returning to the negotiating table in good faith with some genuine concessions that appease the Trump administration. For example, the Iranian government could rescind its right to enrich uranium domestically whilst also agreeing to full and open access for the International Atomic Energy Agency (IAEA). By itself that might be sufficient to calm the situation down. If it were accompanied by a commitment to launch no further attacks against US bases, so much the better.