Defense Analysts: Pentagon Will Hit Fiscal Pothole, But Won’t Go Off Cliff

In the fiscal cliff negotiations that are consuming Washington, the defense budget is only a bit player. Military contractors should keep that in mind as they await a resolution to the budget stalemate, analysts and industry insiders said.
Possible cuts to defense spending known as sequestration — about $500 billion over 10 years — have been characterized by Pentagon and industry officials as catastrophic, but in the larger picture of the fiscal cliff talks, the sequestration cuts are just one of many bargaining chips that are being placed on the table by negotiators as each side tries to get concessions on much bigger items such as taxes and health care.
Defense sequestration is only 11 percent of the dollars that are at stake in the fiscal cliff package, said Nora Bensahel, a senior fellow at the Center for New American Security.
The year-end fiscal cliff is a catchphrase that includes the end of last year’s temporary payroll tax cuts, the end of certain tax breaks for businesses, shifts in the alternative minimum tax that would take a larger bite, the expiration of the George W. Bush tax cuts and tax-related implications of President Obama’s health care law. At the same time, spending reductions agreed upon in the debt ceiling deal of 2011 would begin to go into effect.
The idea that defense is playing second and third fiddle at the negotiating table might be a tough pill for the industry to swallow, Bensahel said Dec. 5 at a U.S. Naval Institute conference in Washington, D.C.
She warned an audience of defense contractors to brace for more drama and not to expect military spending to be spared. “Given the incredible political divides, something that is worth only 11 percent of the total isn't going to be a particularly high priority in the negotiations,” she said. “It's likely to be a bargaining chip to the extent that it matters at all.” Defense cuts, said Bensahel, will be “something that you trade for something else. … That's the political reality we are in. At the moment the chances for a grand bargain do not look good.”
Other analysts offer a similar take. Gordon Adams, a former budget official during the Clinton administration and a professor at American University, described the role of defense spending as “residual” in the context of the budget talks. “It's something that gets dealt with as you move along the path,” Adams said at the conference. Most of the high-level discussions deal with health costs and taxes, not defense.
He said cuts are all but inevitable, not because of the fiscal cliff, but because two major wars are ending. Regardless of the outcome of the negotiations, he predicted the Pentagon will “go over a pothole, not a cliff.” The politicians will find a way to avoid sequestration, he said, because the “embarrassment factor is too great.”
But if sequestration does happen, Pentagon officials behind close doors are beginning to come to grips with the possibility, Adams said. Uniformed personnel are exempt. Acquisition programs would be hard hit, but he was told by Pentagon procurement managers that the cuts — about 9.2 percent across the board — would be manageable. “That’s what they pay me to do,” a program manager told Adams.
In the financial markets, odds markers are betting a deal will emerge that averts sequestration, said James McAleese, principal at McAleese & Associates, a defense consulting firm. “We know we are going to get out of it,” he said. “Defense stocks have been trading at a 52-week high,” said McAleese. “They think we are going to see a deal.”
Wall Street optimism, however, doesn’t mean investors expect the defense budget to remain untouched. McAleese predicts cuts to the $525 billion 2013 base budget of $15 billion to $20 billion, which is about 3 to 4 percent. The market is betting on worst-case scenario of 5 percent, he added.
Investors and company executives just want the whole melodrama to be over, he said. The process has turned too emotional, he said, and is “keeping us from starting the healing process after the election.” The budget gridlock also is distracting everyone from bigger, arguably more important issues, said McAleese. During an investors conference in New York City last week, he said, “I was astounded that out of 400 people over two days, no one asked me how our 68,000 soldiers and Marines are doing in Afghanistan. … This thing is sucking the oxygen out of the room.”
The notion that defense spending has become a tradable bargaining chip has rankled industry leaders. Aerospace Industries Association President and CEO Marion C. Blakey, who has led a massive lobbying campaign against sequestration, said she was disappointed by the latest developments in the political horse trading.
“The fact that the world’s arsenal of democracy has been relegated to the status of a political bargaining chip is difficult to fathom,” Blakey said Dec. 5 at AIA’s year-end lunch event in Washington.
Earlier this week, top industry officials representing AIA acknowledged that they expect reductions to defense spending. They also voiced support for tax increases if that were necessary to achieve a grand bargain. Their comments were notable in that they recognized that the industry’s lobbying campaign, based on projections that sequestration could wipe out more than 2 million jobs from the U.S. economy, did not keep defense spending off the bargaining table.
Blakey said the CEOs did not “break ranks” with AIA’s positions and simply were stating the reality of the situation.
She said she could not quantify the impact that sequestration would have on defense sales. AIA’s year-end review paints a picture of a healthy aerospace and defense industry. Sales are projected to increase by 3.8 percent from $210.8 billion in 2011 to $217.9 billion in 2012, Blakey reported. The projected sales increase, along with an expansion of aerospace and defense exports from $85.3 billion in 2011 to an estimated $95.5 billion in 2012, is largely due to strong civil aircraft sales. The industry’s positive trade balance rose from $55.8 billion in 2011 to an estimated $63.5 billion in 2012, the largest trade surplus of any manufacturing industry, Blakey said.
Aerospace employment increased modestly from about 625,000 at the end of 2011 to more than 629,000 in the last quarter of 2012, despite layoffs in some facilities supporting military programs, she said.
For many companies, commercial sales are becoming a safety net in the face of uncertainty in the defense market. Military contractor Rockwell Collins is a case in point. The company’s business is split 50-50 between defense and commercial customers. Whereas defense revenues have declined, commercial sales are growing about 7 percent a year, said Bobby Sturgell, Rockwell’s senior vice president for Washington operations. “There will be job losses [on the defense side] by the spring when these cuts occur,” he said. What can Congress do? Make a grand bargain, and the bigger, the better, Sturgell said. Entitlement programs must be tackled, he said. “That’s where the money is.”
Photo Credit: iStockphoto

Topics: Business Trends, Doing Business with the Government, Defense Department, Defense Watch, DOD Budget