‘Dangerous World’ Rhetoric Not Driving Up Defense Spending

An alarmist chorus of military leaders and members of Congress is warning of multiplying threats to U.S. and global security. These code red alerts provide ammunition to pundits and presidential candidates, but are not likely to spark an increase in military spending, according to defense industry watchers.

The defense sector faces less dismal prospects today than it did two years ago, but is not close to returning to the “rah rah boom boom years,” said Andrew Carolus, managing director for aerospace and defense at Mesirow Financial.

Russian saber rattling and Islamic State advances in the Middle East may create enough political pressure to stabilize defense spending but are not seen as catalysts for bigger budgets, Carolus told National Defense. “We are not seeing an increase based on security threats.” The simple explanation is that there is no political will to put boots on the ground, he added. “There is more of a hands off foreign policy than we have seen historically. Until that changes, I don’t think we are going to see any wholesale increase. At the same time I don’t think you are going to see change downwards.”
Carolus’ firm specializes in corporate mergers and acquisitions. The moves that are now being made in the M&A world are a clear sign that defense spending has hit bottom and there is less uncertainty than there was a year ago. “The private equity community is starting to get active again. That’s a sign that the broader M&A market for defense will start to pick up. This tells me there is confidence that there’s opportunity in this space.”

The one anomaly may be the decision by United Technologies to sell helicopter manufacturer Sikorsky. This was a surprising move, said Carolus. “They are getting out almost at the worst possible time. If you believe that defense has bottomed out and has nowhere to go but up, or at least sideways, they are timing the market a little bit strangely.”

Some investors have been looking for a way out of the defense market and now may be the time to do it. “I am still seeing companies exit the defense business,” said Byron K. Callan, managing director of Capital Alpha Partners. There has been a series of major breakups in recent years of companies that had commercial and defense businesses. “I’m not seeing companies making acquisitions to try to get into the defense business,” he said at a Lexington Institute conference on Capitol Hill.

The reason Pentagon contractors may be less attractive to buyers is not necessarily how much the Pentagon spends but the cultural gulf between the defense industry and the rest of the economy. Defense companies struggle to attract the best talent and continue to shortchange investments in innovative products so they can pay shareholders a healthy return.

Callan agrees with other analysts that defense firms are not going to see huge gains from the current geopolitical crises. “ISIS has been a sentiment factor, and has contributed to the ‘world is dangerous’ meme.”

The Joint Chiefs of Staff unveiled this month a new national military strategy that highlights an increase in global instability and notes that some of the United States’ military advantages may be eroding, but makes no mention of defense budgets.

“These are themes that will reappear in the 2016 presidential campaigns and national security policy debates,” Guggenheim Securities industry analyst Roman Schweizer wrote in a research note to investors.

Domestic politics rather than foreign crises are the real driving force in defense spending. The Republican leadership in Congress said earlier that there would be a “regular order” budget process in order to avoid temporary stopgap funding measures and government shutdowns. So far, however, “There is still little change in the political environment and a fall standoff remains extremely likely,” Schweizer noted. “Our base case is a continuing resolution covering several months, with a small chance of a shutdown.” A bipartisan deal to boost spending above the limits set in the Budget Control Act is possible, although “we think it will be below the level of spending for defense in the GOP budget plan.”

The Obama administration has proposed a base defense budget of $561 billion, or $38 billion above the BCA caps, in addition to a $50.9 billion request for overseas contingency operations, or OCO. Both chambers of Congress have approved base defense budgets at the BCA level of $523 billion but added $38 billion to the OCO fund. Obama officials have said the president would veto the congressional funding plan because it provides no relief from the BCA $493 billion cap for nondefense discretionary accounts. The president’s budget increases discretionary spending over the BCA cap by $75 billion: $38 billion for defense and $37 billion for non-defense.

Any defense increase will need to be accompanied with a similar increase in domestic nondefense programs in order to win support from the White House and congressional Democrats in Congress.
“We will not know the outcome on defense spending until September or October, or even later,” Schweizer said. “We think the final outcome will not be known until sometime this fall and could culminate with brinkmanship on funding the government and the debt ceiling extension. A continuing resolution, most likely through the end of December, would seem likely, and a government shutdown is very possible at the start of the fiscal year.”

Topics: Business Trends, Mergers and Acquisitions, Defense Department, DOD Budget