By Saqib Iqbal Ahmed

NEW YORK (Reuters) - Escalating tensions in the Middle East have dampened investor confidence and raised concerns about how riskier assets, including the highly valued U.S. stock market, might respond if the situation worsens.

Stocks tumbled on Tuesday and investors rushed to safe-haven assets such as Treasuries and the dollar, after Iran fired a salvo of ballistic missiles at Israel. Iran said the attack was a retaliation for Israel’s campaign against Tehran's Hezbollah allies in Lebanon. Israel said the attack was serious and would have consequences.

The S&P 500 sank as much as 1.4% but later pared losses to close down 0.9%, while the Nasdaq Composite Index lost as much as 2.3% but also rebounded to finish the day 1.5% lower. Buying was heavy in popular destinations for nervous investors such as gold, Treasuries and the dollar.

Past bouts of heightened geopolitical tension, such as Russia’s invasion of Ukraine in 2022, resulted in sharp but short-lived market moves during which investors fled risky assets and piled in to safe havens such as gold and the dollar.

This time around, further market reaction could depend on Israel’s response and whether the conflict between the two archenemies escalates, investors said.

"The market ... is highly sensitive to any scenario worse than this," said Hasnain Malik, head of emerging and frontier markets equity strategy at Tellimer.

A previous round of Iranian missiles fired at Israel in April - the first ever - were shot down with the help of the U.S. military and other allies. Israel responded at the time with airstrikes in Iran, but wider escalation was averted.

Stocks and other risky assets sold off in April but rebounded within days as fears of a broader conflict and economic disruption dissipated.

However, "if the war escalates, that of course is not good for markets," said Allan Small, senior investment adviser with Allan Small Financial Group with iA Private Wealth in Toronto.

One specific concern for investors is oil prices, which jumped on Tuesday. Investors worry that the fears of supply disruptions of crude oil from the Gulf region will drive prices sharply higher, as has happened during prior periods of intense strain or conflict.

"The deeper the conflict intensifies, oil could indeed surge higher as risk rises that the military response veers into the oil producing area around Iran," Quincy Krosby, chief global strategist for LPL Financial, said in a note.

Beyond tensions in the Middle East, there are several potential market catalysts that could keep investors on edge, including the upcoming U.S. election in November and a key jobs report this week that will help shape the Federal Reserve's policy direction.

The Cboe Volatility Index, an options-based indicator of demand for protection from market swings, rose to a three-week high of 20.73 on Tuesday, before paring gains to trade at 19.25.

"Although the VIX is edging higher it remains sufficiently just below 20 to suggest that markets - including the crude oil market - do not yet envision an all-out military scenario," Krosby said.

Meanwhile, pricing on SPDR S&P 500 Trust ETF options expiring on Nov. 8, just three days after the U.S. election, imply a move of nearly 2% for the S&P 500 Index-tracking ETF on expiration day, according to options analytics service ORATS.

"This reflects traders’ expectations of significant market volatility surrounding the election," ORATS founder Matt Amberson said.

Nearer-term, traders remain focused on the September payrolls report due on Friday, with SPY options primed for a 1.1% swing on the day, signaling expectations for potential surprises in the unemployment data, Amberson said.

For now, market participants are left guessing whether the latest bout of fear will prove fleeting. "Markets, hence, are likely to display an incredibly high sensitivity to incoming geopolitical news flow in the coming hours," said Michael Brown, senior research strategist at Pepperstone.

(Reporting by Saqib Iqbal Ahmed in New York; Additional reporting by Suzanne McGee, Bansari Mayur Kamdar, Lisa Pauline Mattackal and Lewis Krauskopf; Writing by Ira Iosebashvili; Editing by Megan Davies and Matthew Lewis)