Defense Forecast: So Many 'What-Ifs'

Uncertainty remains the operative word in the defense sector. The chances that Congress will pass a defense appropriations bill by Sept. 30 appear to be slim to none. Policy decisions are on hold pending mid-term elections, but gridlock is likely to continue regardless of the outcome.

Also looming is the prospect of automatic budget cuts — starting in 2016 and extending through 2021 — that would be triggered if federal agencies fail to comply with the spending limits set by the 2011 Budget Control Act.

For Pentagon contractors, many unanswered questions remain on how the Defense Department will adjust programs as spending declines, and how long a projected "procurement holiday" might last.

In his latest "Defense Scorecard," Capital Alpha analyst Byron Callan warns industry investors that while Pentagon spending will be stable in the near term, wild cards loom large after 2016.

Despite Congress' best efforts to return to regular order, the Defense Department is unlikely to see its 2015 budget passed when the new fiscal year begins Oct. 1. "At least one or more continuing resolutions are likely," Callan says. "We see this as business as usual so it's not catalytic for defense stocks, so long as there is an 2015 appropriations act by early spring 2015."

What happens beyond 2015, however, "may challenge bullish sentiment," the scorecard cautions. The Obama administration in March proposed a 2016-2019 military budget that exceeds the mandatory caps by $115 billion. The plan got a lukewarm reception on Capitol Hill. And so far lawmakers have shown little inclination to undo the Budget Control Act.

Defense hawks like Rep. Paul Ryan, R-Wisc., have called for increases to the Pentagon's budget but only if they are offset by domestic spending cuts and not by new tax revenue — which makes such proposal a nonstarter. Whether the November election moves the needle is a guessing game.

"The mid-term election will provide a better read on when fiscal year 2015 could be completed and should inform fiscal year 2016's prospects," says Callan. "We see the mid-term congressional elections in the U.S. as a gating factor for defense expectations, with investors starting to pay much more attention to election implications in September."

Defense stocks could perk up if it appears more likely that Republicans take over the Senate, he adds. "The belief only rests on the notion that Republican control could further sharpen foreign policy debates with the White House and suggest potential for more bellicose action."

Further gridlock in Washington, Callan notes, could jeopardize White House budget plans for 2016 that propose 15 percent growth in defense investments from the 2015 request.

A Republican sweep in November, however, does not guarantee that the Pentagon will be spared from the ax, he says. "Unless there are events that appear far more threatening or disruptive to Americans — another major terrorist attack, or $6 a gallon gasoline — we doubt the Republican gains could be translated into substantially higher levels of U.S. defense spending than is now planned by the administration." The House budget resolution earlier this year envisioned defense spending about 1 percent more than the 2015-19 plan. For the administration to secure the extra funding for defense, Congress and the White House would have to find some way to compromise on a wider range of spending and revenue issues.

"We could see defense stocks with U.S. exposure generally move higher if investors and analysts believe that the fiscal year 2016 defense plan for procurement and RD&TE (research and development) budget authority could be realized," says Callan. The plan shows procurement up 20 percent from the 2015 request and RDT&E up 9 percent. Growth projections slow down in 2017 and beyond to mid-low single digits. "We still think that the final outcome will be investment spending levels somewhere between the plan and budget cap levels for fiscal year 2016 and beyond."

Conflicts and political crises do not appear to spur any moves to increase military budgets. "With the possible exception of Saab Group in Sweden, very few defense stocks appear to have reacted to Russian actions in Ukraine, the war in Syria, the potential fragmentation of Iraq and wider implications of war in the Levant," Callan says.

Another matter of concern to defense industry is how the Pentagon will choose to spend its investment dollars — specifically whether it will start looking at alternatives to current programs of record, he says. "Right now, we don't see evidence of disruptive changes. But we still wonder if all the emphasis on innovation, rapidly evolving adversary capabilities, costs of current weapons programs and potential lower-cost alternatives won't spawn new programs that challenge the current order." Defense officials have been talking more openly about the erosion of U.S. defense superiority, but have not explained what they will do about it.

In the long term, the outlook is indeed worrisome for the defense sector, according to analystsClark A. Murdock and Ryan Crotty, of the Center for Strategic and International Studies.

"The post 9/11 defense drawdown will be significantly deeper than is generally recognized," the authors warn in a new study. Because of the "double whammy" of topline cuts and the decreasing purchasing power of defense dollars, a steep downsizing can be expected between now and 2021.

Murdock suggests the Pentagon should immediately start shedding personnel and programs before automatic budget cuts return. "The Defense Department needs to adopt a dramatically different approach to force planning grounded in the acceptance of the BCA caps," he says.

The military's base budget (not including war funds) peaked in 2012 at $660 billion. By fiscal year 2021, it will be $520 billion, a decline of 21 percent. During this same period, the defense dollar will have lost 15 percent of its purchasing power, CSIS analysts estimate, because defense expenditures are rising faster than inflation. They predict that the combined impact of growth above inflation of personnel, health care, operations, maintenance and acquisitions will erode procurement spending.

The 2021 fiscal reality is a "harsh one," Murdock says. The Defense Department will have 21 percent fewer dollars to buy military capabilities and each of those dollars will have lost 15 percent of their purchasing power. The Pentagon has yet to confront this problem, he says. "The correct response is not denial and the continued submission of defense budget requests that do not conform to the BCA."

Chronic indecision on how to restructure the military for the future is part bureaucratic inertia but also not knowing what threats the nation will face. Retired Marine Corps Gen. Tony Zinni, former chief of U.S. Central Command, says the Pentagon cannot continue to put off tough decisions.  

"Today it's very difficult to determine the kind of military we need," Zinni states in a new book, titled, "Before the First Shots Are Fired," that is scheduled for release this fall.

The Pentagon has to determine what capabilities it should fund to keep a "qualitative edge," he says. "Since we can't keep all our capabilities at their highest possible levels, which ones can we risk weakening?"

The military also has to carefully rebalance the force between active and reserves, Zinni suggests. "We can't keep guessing these questions," he says. "Admittedly, we live in an unpredictable world but we know that the threats to us will be split between low end and high end. ... What is the best force structure to meet challenges of transnational threats such as terrorism, instability, insurgencies and international criminal activities?" he asks. The biggest question: "What can we afford?"

Topics: Business Trends, Business Development, Doing Business with the Government, Defense Department, DOD Budget, DOD Policy, Procurement