Taking Stock of the Sequester

by Wendy Simmons | February 21, 2013 1:32 pm

In exchange for raising the debt ceiling way back in the summer of 2011, Congress charged a super-committee with designing a large-scale deficit reduction package — or else. The super-committee failed, and that “or else” is now upon us. The U.S. economy faces a serious self-inflicted wound on March 1, barring a still-elusive political compromise.

Throughout the final grueling days of the 2012 presidential election, President Obama and the GOP leadership both assured us that the draconian, immediate cuts to the federal budget known as “the sequester” would not happen. Political observers across the board agreed that Congress and the president would find some way to work together in order to avoid the austerity package. Indeed, the fiscal cliff negotiations of December seemed to confirm that general view — the cuts were postponed for two months. As recently as three weeks ago, defense contractors would not even entertain the idea[1] that their piece of the federal pie might be smaller on March 1.

That consensus has vanished. It looks like the cuts are going to happen.

Despite an aggressive push by the White House to educate the public on the possible fallout[2] from the sequestration cuts, the GOP seems to have concluded that the law as written is better than negotiating with the president on alternatives[3]. Tom Cole (R-Okla.), the House deputy majority whip, made clear earlier in the month that the cuts were “going to happen” and “need to happen.” This certainty comes in spite of the rare bipartisan consensus on the terrible construction of the cuts.

Let’s take a look at the numbers.

As current law is written, the federal government will cut $85 billion in spending over the next eight months, starting March 1. This translates to a 13% cut to defense spending and a 9% cut to other non-discretionary spending. (In other words, entitlement programs like Social Security and Medicare are spared from all of this.) The Congressional Budget Office estimates that cutting federal agencies in this way will shave 0.7% off of GDP this year. Others project that 1 million jobs will be lost in the wake of the austerity measures.

The political lines in the sand are clear … and familiar. Although both sides want to replace automatic cuts, Obama claims he will not replace sequestration with anything that doesn’t include new revenue, and the GOP counters by saying they absolutely will not consider raising taxes. As the effects of this austerity package start to ripple down through the economy in the form of layoffs, furloughs, decreased consumer confidence and business activity, we may see those positions change as the public digests the reality. Obama continues to believe that the public sides with him on the need to include new revenue in the budgeting process.

What’s at Stake: Defense Industry

A critical aspect of the sequester legislation is that it requires that agencies — including the Defense Department — cut all of their departments and programs by the same percentage. This means that the heads of federal agencies will not have a lot of flexibility[4] to shift monies around from less critical programs and services to crucial ones.

If the Defense Department’s budget is actually cut by 13% on March 1, we will likely see its contractors take a big hit. Earlier in February, in fact, Obama’s staff met with several major defense contractors, such as Northrop Grumman (NYSE:NOC[5]), Pratt & Whitney (a division of United Technologies (NYSE:UTX[6])) and BAE Systems (PINK:BAESY[7]), to discuss the potential consequences for their businesses. Jay Carney, the White House spokesman, noted that Northrup Grumman, maker of (among other things) aerial drones for the U.S. military, uses about 20,000 smaller businesses[8] in filling federal orders. So when contracts are canceled or delayed, it’s not just the large companies that will feel the hit, but their entire supply chains as well.

And beyond the suppliers of real goods to the military, smaller local economies that depend on the spending associated with military conferences and events have already started to feel the pinch[9].

Although congressmen and pundits are signaling doomsday scenarios for our defense capabilities and the future of the companies that serve them, so far the reaction among investors in these sectors has been muted. Why? Perhaps because these large defense contractors understand how the legislative and appropriations process might actually work.

Let’s assume the sequester cuts kick in and the DOD really does have to start tightening its belt on March 1. There is simply no reason that John Boehner and his GOP colleagues can’t reallocate money for defense after the cuts have taken place. The logic is similar to that of the fiscal cliff. If all of the Bush tax cuts had been allowed to expire, then the Democrats could have forced the GOP to vote against lowering rates. In the same way, if all of these cuts take place across the board, the GOP will be forcing the Dems to vote against allocating money for defense, rarely a popular position[10].

There is no guarantee that Boehner will be able to convince his most conservative members to increase spending on defense somewhere down the line, or that Obama won’t veto this effort. But for now anyway, defense companies seem to be betting that at the end of the day, Congress and the president don’t actually have the nerve to take such a big slice out of the DOD.

Endnotes:
  1. would not even entertain the idea: http://www.washingtonpost.com/business/economy/sequestration-looms-contractors-dont-fret/2013/01/30/3bcf60ea-6b0a-11e2-af53-7b2b2a7510a8_story.html
  2. fallout: http://www.whitehouse.gov/the-press-office/2013/02/08/fact-sheet-examples-how-sequester-would-impact-middle-class-families-job
  3. alternatives: http://www.washingtonpost.com/opinions/charles-krauthammer-call-obamas-sequester-bluff/2013/02/07/5f64a24e-7150-11e2-ac36-3d8d9dcaa2e2_story.html
  4. will not have a lot of flexibility: http://www.washingtonpost.com/blogs/wonkblog/wp/2013/02/08/read-the-white-house-explains-how-the-sequester-cuts-would-work/
  5. NOC: http://studio-5.financialcontent.com/investplace/quote?Symbol=NOC
  6. UTX: http://studio-5.financialcontent.com/investplace/quote?Symbol=UTX
  7. BAESY: http://studio-5.financialcontent.com/investplace/quote?Symbol=BAESY
  8. 20,000 smaller businesses: http://www.usatoday.com/story/theoval/2013/02/06/obama-valerie-jarrett-defense-contractors/1896447/
  9. already started to feel the pinch: http://blog.al.com/breaking/2013/01/travel_and_training_cuts_force.html
  10. rarely a popular position: http://blogs.barrons.com/stockstowatchtoday/2013/02/08/another-view-of-the-sequester-and-defense-stocks/

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