The failure of the U.S. congressional super committee to reach a deal on reducing the budget deficit by $1.2 trillion over 10 years implies that uncertainty over defense spending is set to continue into 2012.
With the collapse of the super committee and its goal of identifying $1.2 trillion in deficit reduction, we expect uncertainty now over the outlook for defense spending to continue well into 2012, and likely through the 2012 November presidential election, Wedbush Securities analyst Kenneth Herbert, wrote in a note to clients.
Under the Budget Act of 2011, the next important deadline is Jan. 15, 2012, when the trigger for the $1.2 trillion in budget cuts is expected to go into effect. But Congress has the power change this or to pass legislation ahead of time that can alter the process.
There has been speculation that the House of Representatives, led by Rep. Buck McKeon, R-Calif., chairman of the Armed Services committee, will introduce legislation to shield the Department of Defense from the sequestration process. President Barack Obama says he will veto any such legislation, forcing Congress to approach the deficit-reduction efforts for all areas of spending equally.
Herbert expects the DoD to significantly increase its public posturing about the potential negative impact on jobs, the economy and national security if they resort to sequestration to reduce the deficit. Secretary of Defense Leon Panetta has already started down this path, outlining what the cuts could do to specific programs and employment levels both at contractors and in the armed forces.
We expect this to play into the pro-defense congressional caucus. However, we are not sure how effective this will be, as we believe public opinion is largely supportive of at least some cuts to defense spending as part of any deficit reduction efforts, the analyst said.
This will play into the political process, as Republicans will tend to be more supportive of the DoD while Democrats will tend to want the sequestration efforts to hit all agencies equally as a way of boosting their push for revenue, or tax, increases, as part of the overall deficit-reduction solution.
It must be noted that the actual orders from the Office of Management and Budget for sequestrations for defense and non-defense categories of spending necessary to hit the trigger spending cuts are not due to hit until January 2013.
The DoD has recently indicated that, of its already announced plans to reduce spending by $240 billion (part of an initial $350 billion to $400 billion in savings effort) that about half of the savings will come from investment accounts and half from efficiencies and personnel.
In order to bridge the approximately $500 billion to $600 billion gap between already announced cuts and the trigger amounts, the analyst expects that a disproportionate amount may fall on the investment (R&D and procurement) accounts. It is true that reductions in troop levels can have the most immediate savings but these will also create unemployment on a large scale, as a number of troops coming out of the military today are unemployed.
We believe the DoD will be forced to look at significant reductions to larger procurement and R&D categories, such as the Joint Strike Fighter, Herbert said.
The analyst recommends that investors looking for exposure to the commercial aerospace cycle but with limited defense exposure consider Spirit AeroSystems (NYSE:SPR), Precision Castparts (NYSE:PCP), TransDigm (NYSE:TDG) and HEICO (NYSE:HEI).
Herbert said the stocks that will be most negatively impacted by the continued debate and uncertainty regarding the outlook for defense spending are Rockwell Collins (NYSE:COL), AAR (NYSE:AIR), Boeing (NYSE:BA), Curtiss-Wright (NYSE:CW), Ducommun (NYSE:DCO), ViaSat (NASDAQ:VSAT) and Triumph Group (NYSE:TGI).