The Gulf economies will shrink by about 5% this year, a slump on a par with the pandemic, as the Iran war drags on with no decisive end in sight, Capital Economics said in its quarterly regional outlook on September 22.

The London-based consultancy expects a slow and bumpy recovery. Energy exports are unlikely to return to pre-war levels until at least early 2027, while non-oil activity will be held back by a lack of fiscal support, interest rate hikes that track the US Federal Reserve and struggling tourism sectors. It thinks consensus forecasts are underestimating the damage.

"The hit to the Gulf economies hasn't been quite as bad as we initially feared," economists Jason Tuvey, William Jackson and Nicolas Crittenden wrote, but "consensus forecasts don't seem to fully appreciate the scale of the economic damage."

The unravelling of June's memorandum of understanding has not so far led to a return to the intense hostilities seen earlier in the war, according to the note. The US naval blockade is straining Iran's economy and moderate voices in the regime seem open to fresh talks, but a lasting deal will be difficult to secure.

Energy flows have picked up as producers adapt with pipelines and shuttle runs, yet traffic through the Strait of Hormuz remains constrained. Only three commercial vessels crossed the strait on September 16, down from a 10-day average of around 17, even as Saudi crude flows through an Omani workaround gathered pace.

Capital Economics forecasts Brent crude at $100 per barrel at the end of 2026, close to its current $99.4, before it falls to $70 at end-2027 and $60 at end-2028. Asian LNG prices are seen at $28.4 per mBtu at the end of this year, against $26 now. For the Middle East and North Africa as a whole, it forecasts GDP to contract by 1.0% in 2026 before growing by 7.5% in 2027.

Saudi pipeline shutdown puts oil recovery into reverse

The fallout in Saudi Arabia's non-oil economy has been smaller than in most of the Gulf, the consultancy says, but the closure of the East-West pipeline after Houthi attacks has put the recovery in oil output into reverse, at least temporarily. Riyadh has since told European refiners that no crude allocations will be delivered in October.

GDP contracted by 4.8% q/q in the second quarter after a 1.4% q/q fall in the first, driven by the slump in oil output. The non-oil economy fared better than expected but still shrank by 0.3% q/q. In an earlier note on September 14 Capital Economics estimated that each week of the pipeline's closure could knock up to 0.3 percentage points off Saudi GDP.

Its working assumption is that oil output returns to pre-war levels early next year and is then ramped up as Opec tries to claw back market share. Further Houthi attacks and disruption in the Bab el-Mandeb Strait are the downside risks.

The consultancy forecasts the Saudi economy to contract by 2.5% in 2026, whereas the consensus expects a modest expansion, before a 9.3% rebound in 2027. Oil GDP is seen falling 15.5% this year and jumping 33.8% next year, while non-oil GDP grows 1.5% and 3.0%.

There is little room for stimulus. The general government deficit is forecast at 7.5% of GDP this year and debt at 38.3% of GDP, and Capital Economics expects the debt ratio to pass 50% of GDP later this decade even with a fiscal squeeze. Flagship gigaprojects such as Neom will continue to bear the brunt of the cuts.

Monetary policy will not help either. The Saudi central bank raised its reverse repo rate by 25bp to 4.00% on September 16 in step with the Fed, and Capital Economics expects another 25bp hike in December as the Fed delivers a further 50bp of tightening. It has already argued that the slowdown in private sector lending will weigh on the recovery.

UAE oil output ramps up as tourism and property lag

The UAE is being supported by a ramp-up in oil output via the Habshan-Fujairah pipeline and shuttle runs through Hormuz, although growth slowed sharply from 8.5% y/y in the fourth quarter of 2025 to 3.0% y/y in the first quarter as the war broke out. Its exit from Opec means output is likely to rise well above pre-war levels over the medium term, the note says.

Abu Dhabi is well placed to provide fiscal support, with Capital Economics forecasting a budget surplus of 5.5% of GDP this year. But tourism may struggle to regain its pre-war status for some time and the real estate sector is cooling, although recent deleveraging means that is unlikely to cause debt problems. Gulf tourism has so far recovered only where the visitors are Gulf Arabs.

The consultancy sees UAE GDP falling 1.5% in 2026 and rebounding 8.3% in 2027, with inflation peaking at 4.0% this year. The war challenges Dubai's economic model, it says, and its future depends on the course of the conflict and an intense rivalry with Riyadh for pre-eminence in the Gulf. Closer ties with Washington should keep the UAE's access to cutting-edge US technology and its push into AI on track.

Qatar, Kuwait and Bahrain face double-digit contractions

Qatar, Kuwait and Bahrain are expected to contract at a double-digit rate this year because of their limited capacity to export energy. Capital Economics forecasts Qatar's GDP to shrink by 24% in 2026, Kuwait's by 18% and Bahrain's by 11%, followed by rebounds of 29%, 27% and 6.5% respectively in 2027 - contingent on some normalisation of transit through Hormuz.

Qatar is the hardest hit of all the Gulf economies. It relies on LNG, which unlike oil cannot be shuttled through the strait or diverted via pipelines, and Iranian strikes on the Ras Laffan export complex have knocked out close to 20% of output. Doha has extended force majeure on LNG cargoes into early November, and its economy had already contracted by 7% y/y in the first quarter as hydrocarbon GDP collapsed.

Qatar and Kuwait hold savings worth several times their GDP to finance widening deficits, but some austerity is also likely, and Qatar's government has already turned in that direction, the note says. Tight fiscal policy will drag on the non-hydrocarbon recovery.

Bahrain, whose economy shrank by 3.8% in the first quarter, faces a large fiscal hit without big assets to draw on and will need financing from its neighbours to avoid a devaluation and default. Its CDS premia remain below their peaks at the start of the war, probably because markets expect further Gulf support, and Capital Economics' base case is that it will be forthcoming.

Oman is the exception. Its economy will continue to benefit from undisrupted exports and high prices, with GDP forecast to grow 4.5% this year, and the improved fiscal position may give policymakers room to provide support.

Egypt weathers the shock

Egypt has managed the energy shock well, helped by improved policymaking, according to Capital Economics. Growth stood at 5.0% y/y in the first quarter and survey data suggest activity slumped when the war broke out but has since largely recovered.

Higher energy prices will keep the trade deficit wide, but the pound has been allowed to fall in response and foreign exchange reserves, which hit a record $57.2bn in August, offer sizeable buffers alongside an IMF deal. The consultancy expects the pound to weaken from EGP51.92 per dollar now to EGP55 by end-2026 and EGP60 by end-2027.

It forecasts GDP growth to slow to about 4.3% this calendar year before picking up to 4.8% in 2027 and towards 5.5% in 2028. A weaker pound and higher local fuel prices will keep inflation elevated, so the Central Bank of Egypt is expected to hold its overnight deposit rate at 19% for the rest of the year, in line with calls from Morgan Stanley and EFG Hermes.

Further ahead Capital Economics is more dovish than the consensus. It expects inflation to fall into the central bank's 5-9% target range by early next year, allowing 600bp of cuts that take the policy rate to 13.00% by end-2027 and 11.50% by end-2028.

Morocco resilient, Tunisia heading for crisis

Morocco is likely to record only a modest slowdown, with growth easing to about 3.3% this year before rebounding to 4.8% in 2027 as it integrates further into EU supply chains and draws Chinese investment. Consumer prices fell 0.6% y/y in July on lower food prices and the external position is strong, though the energy crisis has probably delayed the central bank's planned move to a flexible exchange rate.

Tunisia is "heading down the path towards a messy economic crisis", the consultancy warns, extending an analysis it published earlier this month. The dinar is significantly overvalued, the current account deficit is set to widen further, reserves offer a limited buffer and an IMF deal appears to be off the cards.

Capital Economics expects the dinar eventually to be devalued by up to 30% against the euro, pushing inflation up to 7.3% in 2027. With more than 40% of sovereign debt denominated in foreign currency and little appetite for fiscal tightening, it thinks the government is likely to turn to default to address the debt problem.

A lasting mark

Whatever the outcome, the war will leave a lasting mark on the Gulf, according to the note. Pipelines and export terminals will play a bigger role in reducing reliance on Hormuz, diversification plans are likely to move away from large investment projects, and the region's diplomatic embrace of Washington may weaken, the UAE aside, while the war adds fuel to the Saudi-UAE rivalry.