By Noel Randewich

(Reuters) -Financial markets may be in for a "knee-jerk" selloff if the U.S. military attacks Iran, with economists warning that a dramatic rise in oil prices could damage a global economy already strained by President Donald Trump's tariffs.

Oil prices fell nearly 2% on Wednesday as investors weighed the chance of supply disruptions from the Israel-Iran conflict and potential direct U.S. involvement. The price of crude remains up almost 9% since Israel launched attacks against Iran last Friday in a bid to cripple its ability to produce nuclear weapons.

With major U.S. stock indexes trading near record highs despite uncertainty about Trump's trade policy, some investors worry that equities may be particularly vulnerable to sources of additional global uncertainty.

Chuck Carlson, chief executive officer at Horizon Investment Services, said U.S. stocks might initially sell off should Trump order the U.S. military to become more heavily involved in the Israel-Iran conflict, but that a faster escalation might also bring the situation to an end sooner.    "I could see the initial knee-jerk would be, 'this is bad'," Carlson said. "I think it will bring things to a head quicker."

Wednesday's dip in crude, along with a modest 0.3% increase in the S&P 500, came after Trump declined to answer reporters' questions about whether the U.S. was planning to strike Iran but said Iran had proposed to come for talks at the White House. Adding to uncertainty, Iranian Supreme Leader Ayatollah Ali Khamenei rejected Trump's demand for unconditional surrender.  

U.S. Treasury yields fell as concerns over the war in Iran boosted safe haven demand for the debt.

The U.S. military is also bolstering its presence in the region, Reuters reported, further stirring speculation about U.S. intervention that investors fear could widen the conflict in an area with critical energy resources, supply chains and infrastructure. 

With investors viewing the dollar as a safe haven, it has gained around 1% against both the Japanese yen and Swiss franc since last Thursday. On Wednesday, the U.S. currency took a breather, edging fractionally lower against the yen and the franc.

“I don't think personally that we are going to join this war. I think Trump is going to do everything possible to avoid it. But if it can't be avoided, then initially that's going to be negative for the markets,” said Peter Cardillo, Chief Market Economist at Spartan Capital Securities in New York. "Gold would shoot up. Yields would probably come down lower and the dollar would probably rally."

Barclays warned that crude prices could rise to $85 per barrel if Iranian exports are reduced by half, and that prices could rise about $100 in the "worst case" scenario of a wider conflagration. Brent crude was last at about $76.

Citigroup economists warned in a note on Wednesday that materially higher oil prices "would be a negative supply shock for the global economy, lowering growth and boosting inflation—creating further challenges for central banks that are already trying to navigate the risks from tariffs." 

Trump taking a "heavier hand" would not be a surprise to the market, mitigating any negative asset price reaction, Carlson said, while adding that he was still not convinced that the U.S. would take a heavier role.

Trades on the Polymarket betting website point to a 63% expectation of "U.S. military action against Iran before July", down from as much as an 82% likelihood on Tuesday, but still above a 35% chance before the conflict began last Friday.

The S&P 500 energy sector index has rallied over 2% in the past four sessions, lifted by a 3.8% gain in Exxon Mobil and 5% rally in Valero Energy. That compares to a 0.7% drop in the S&P 500 over the same period, reflecting investor concerns about the impact of higher oil prices on the economy, and about growing global uncertainty generated by the conflict.

Turmoil in the Middle East comes as investors are already fretting about the effect of Trump's tariffs on the global economy. 

The World Bank last week slashed its global growth forecast for 2025 by four-tenths of a percentage point to 2.3%, saying that higher tariffs and heightened uncertainty posed a "significant headwind" for nearly all economies.

Defense stocks, already lifted by Russia's conflict with Ukraine, have made modest gains since Israel launched its attacks. The S&P 500 Aerospace and Defense index hit record highs early last week in the culmination of a rebound of over 30% from losses in the wake of Trump's April 2 "Liberation Day" tariff announcements.

Even after the latest geopolitical uncertainty, the S&P 500 remains just 2% below its February record high close. 

"Investors want to be able to look past this, and until we see reasons to believe that this is going to be a much larger regional conflict with the U.S. perhaps getting involved and a high chance of escalating, you're going to see the market want to shrug this off as much as it can,” Osman Ali, global co-head of Quantitative Investment Strategies, said at an investor conference on Wednesday.

(Reporting by Noel Randewich in San Francisco; additional reporting by Steven Culp, Lewis Krauskopf and Sinead Carew in New York; Editing by Megan Davies)