(Editor's Note: CreditWeek is a weekly research offering from S&P Global Ratings, providing actionable and forward-looking insights on emerging credit risks and exploring the questions that matter to markets today. Subscribe to receive a new edition every Thursday at: https://www.linkedin.com/newsletters/creditweek-7115686044951273472/)

As the Middle East conflict escalates and expands one year after its onset, we now anticipate the situation will persist into next year—with potentially lingering aftereffects and a greater likelihood of developments that could weigh on regional sovereign credit ratings, disrupt supply chains, trigger risk aversion across markets, and shift governments' spending priorities.

What We're Watching

Geopolitical risk remains high as the Israel-Hamas-Hezbollah conflict intensifies, human costs mount, and a lasting resolution remains out of sight. The war in Gaza is also stoking ethnic tensions across the world, risking outbreaks of violence and more terrorism.

In the Middle East, any lasting political settlement on the Palestine question is currently unlikely. The recent intensification of hostilities between Israel and Hezbollah (including the former's ground invasion of Southern Lebanon) has increased the potential for a more forceful and damaging action-and-reaction cycle between Israel and Iran. This risks dragging more countries into the conflict.

In our view, the potential for regional wars to spill over is the top risk to European credit conditions. Credit conditions in emerging markets face the high and worsening risk that geopolitical tensions and difficult sociopolitical conditions could erode credit fundamentals.

While the geopolitical confrontation in the Middle East represents a significant source of event risk, the impact on sovereign credit metrics has so far been limited to Israel and Lebanon as the two rated sovereigns involved. Our rating on Israel (A/Negative/A-1) is now two notches lower than on Oct. 7, 2023—reflecting weaker fiscal and growth expectations through 2025, as well as significantly increased security risks. Although Lebanon remains in default, we believe its economic and recovery prospects have also been weakened.

The expansion and escalation of the conflict poses risks for regional sovereign ratings. While our sovereign ratings in the region already factor in the temporary emergence of geopolitical stress, we believe that (under a further increasing stress level) several transmission channels—including changing energy prices, trade-route security, tourism revenue, remittances, and the potential for capital outflows—could potentially create more material credit implications across the rest of the region, with their sensitivity stronger in some sovereigns than others.

What We Think And Why

We believe the complex and unpredictable conflict is likely to persist well into 2025. In our base case, we view the likelihood of a protracted, direct conflict between Iran and Israel/the U.S. as limited. However, it now appears more likely that regional military forces aligned with Iran will seek to bolster perceptions of their combined regional military capabilities and inflict damage on Israel and its allies' assets.

In analyzing our stress scenarios, we believe the current regional stress level is moderate—but see the potential for elements of high stress to emerge. We anticipate that regional political volatility and increasing risks of credit disruption will continue. Material economic disruption has intensified for Israel and Lebanon, and may increase for the wider region—which could result in the emergence of downward rating pressure.

What Could Change

Israel's conflict with Hezbollah in Lebanon could become more protracted than anticipated. Given the reported size of Hezbollah's military arsenal, proxy forces may have the scope to initiate attacks against Israel and increase the potential for a miscalculation that could widen the geographical perimeter of direct military engagement.

In a severe stress scenario, Iran, the U.S., and Gulf allies would be drawn into the conflict—potentially triggered by attacks on non-military targets that result in material civilian casualties. This could create enormous uncertainty, affect regional macroeconomic stability, and disrupt commodity markets and regional trade routes.

We continue to monitor key transmission channels exposed to the conflict that would affect credit conditions. These include energy prices, supply chain disruptions, financial market volatility, and resumption of inflationary pressures, all of which could worsen if the conflict reaches a tipping point. These factors could weigh on major central banks' monetary easing calculations, especially if financing conditions tighten.

Increasing oil prices would be particularly harmful for net energy importers, primarily most of the world's major emerging market economies. While the price of Brent crude oil dropped below $75 per barrel in early September (compared with an average of nearly $85 per barrel in the year through August), further escalation of the conflict in the Middle East could send oil prices back up in the coming months—as well as increase energy and shipping costs, and directly weigh on activity for emerging markets in that region.

Although we currently see a low likelihood of direct attacks on oil production facilities in the region given the recently and relatively improved relations between Iran and the Gulf Cooperation Council, the risk of Israeli attacks on Iranian oil facilities or refineries remains.

Conversely, if regional militias ultimately show restraint and a hostage deal that presages a durable ceasefire materializes, tensions may lower and provide an opportunity to restore stability in the region.

Writers: Molly Mintz and Joe Maguire