Market Focus Michael J. McCord, the U.S. Defense Department’s comptroller, warns of dire consequences if more than $1 trillion in approved cuts to military spending over 10 years are allowed to take effect. The result would be the lowest number of ships since World War I, the smallest ground force since 1940 and the smallest Air Force ever, he recently told investors. But later in the same speech, McCord noted that if the full cuts kick in, the Pentagon budget would lose only about half of the 60% it has gained in inflation-adjusted terms since then-President George W. Bush initiated a military buildup in 2001. So is the sky falling on defense contractors? Or are they facing a manageable belt-tightening that will be less painful than the 66% decline in military procurement that came after the Cold War? If you’re confused now, wait until the budget process begins. On Feb. 6, President Barack Obama is scheduled to submit a budget request to Congress that incorporates $489 billion in defense reductions over 10 years—but ignores another $600 billion in automatic cuts that by law will begin next January. A long-term plan to reorient U.S. defense priorities, unveiled on Jan. 5, is based on similar assumptions. Bottom line: There is no plan to deal with the $600 billion reduction. Nobody in Washington is moving to address that disconnect. With elections in November, it is easier to criticize the looming budget cuts or pretend they are not coming than it is to find money to offset them. As Obama campaigns for reelection, he and his Republican opponent “will have to be optimistic about the [defense] budget as they try to woo constituents,” says Bank of America Merrill Lynch analyst Ronald J. Epstein. “Likewise, Congress will likely keep kicking the can down the road.” But with the federal budget deficit exceeding $1 trillion a year, there is no magic bullet that will spare the military. “Beware 2013, when whoever wins the election will have to deal with the reality,” warns Epstein. “We sense that no one is preparing for it.” It is little wonder, then, that 90% of respondents to a new Morgan Stanley investor survey expect defense stocks to be down or flat in 2012. Some industry veterans hope the budget crisis will force the Pentagon to finally get serious about its own entitlements. The department’s spending on health care for 1.5 million active personnel and 1.9 million retirees will top $52 billion this year, up from $19 billion in 2001. “Personnel costs are growing at an unsustainable rate,” says USMC Maj. Gen. (ret.) Arnold Punaro, who heads a defense consultancy. Sens. John McCain (R-Ariz.) and Lindsey Graham (R-S.C.) plan to wage a battle to rescind—or at least reduce—the $600 billion cut. But with their Republican colleagues dead set against tax increases and many Democrats equally dug in against curtailing social entitlements, a pre-election compromise is unlikely. Brace yourself for a lot of rhetoric—and little action. WEEKLY MARKET PERFORMANCE Closing Prices as of January 18, 2011
Source of financial data: Standard & Poor’s and Capital IQ Inc. (a Division of Standard & Poor’s) U.S. dollars and cents. Forward P/E ratio uses S&P and Capital IQ forecasts of current fiscal year.  Click to visit Aviation Week's web site > |
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