Since the Budget Control Act (BCA) imposed caps on federal discretionary spending in 2013, Overseas Contingency Operations (OCO) funding has taken on greater significance than just funding combat operations. Considered "emergency" spending, the BCA's established annual budget caps are automatically increased by the amount of funds appropriated for OCO = budget caps effectively do not apply to OCO spending. The Pentagon received $58.6B in OCO funds in FY 2016, approximately 10.2% of total DoD spending for the year.
Last February the President requested $58.8B in OCO funds for FY 2017 in accordance with the terms of the Bipartisan Budget Act (BBA) of 2015, the two year budget deal which adjusted defense and non-defense discretionary spending caps for FY16 and 17. However, assumptions used to justify the President's OCO request from last February have since changed, i.e., troops in Afghanistan will only be reduced from 9,800 to 8,800 not 5,500 as planned and US combat activity against ISIS is increasing in Iraq, Syria and now, Libya. We estimate that these changes to assumptions will cost at least $4B.
Republican Congressional leaders are clamoring to increase the FY17 OCO request by at least the estimated $4B, but the White House is sticking to the strictest interpretation of last year's budget deal and refusing to accept any additional defense funding, OCO or otherwise, unless non-defense spending is increased by the same amount. OMB has stated that they are willing to find offsets within the overall defense request and reprogram those funds to the additional war costs.
Given the summer doldrums and the empty capital city, this specific debate has not gotten much attention but is reflective of the larger division between the Democratic and Republican parties over non-defense spending. Whereas there is general consensus in Congress, in the Administration and in both major political campaigns that the budget caps on defense spending have to be removed, there is a strong difference in opinion as to whether the caps on non-defense spending should also be lifted.
While $4B is not "nothing", the amount of money is not the point. $4B is certainly an amount that can be dealt with in a overall $583B budget (0.6%) that includes many assumptions about future inflation costs, currency exchange rates, the cost of oil, etc which can always be "adjusted" up front since they are not really known costs until after the fact anyway. The point is that Republicans want to increase defense spending but do not want to increase the caps while the Administration and most Democrats want to raise all discretionary spending caps.
Both Congress and the Administration have taken advantage of OCO funding's exceptional status outside of the budget caps. OCO was supposed to be war-related spending but the line between baseline and war-related funding has become very blurry. The FY 2016 appropriations bill language passed by Congress and signed by the President did not even attempt to maintain the fiction that OCO = war-related spending and simply listed baseline costs as an OCO line item and essentially paid $7.7B in baseline bills with "emergency" funding. For FY17, the President requested $5.2B in OCO funds for baseline costs.
In its version of the FY17 appropriations bill the House took the President's request for baseline spending within OCO to a new dimension by providing for the entire $59B requested for OCO but only funding war operations through April 30! This effectively adds $32B to FY17 baseline accounts using OCO funds, six times what the President requested. More significantly it means that there would have to be a supplemental OCO appropriation before April 30 that ostensibly would become a must pass bill. The White House has said it would veto such a proposal and the Senate has opposed the idea. What actually gets sent to the President will be resolved in conference this fall.
The bottom line for investors is that there continues to be strong upward pressure on the defense budget with consensus that funding must be increased but lots of political games to be played. Although the current budget expires on September 30, we are looking for a Continuing Resolution (CR) that will maintain federal spending at FY16 levels through the election until at least early December. While there is considerable noise about extending the CR into April, we think that very unlikely unless something dramatic (and unexpected) happens in the election. The downside to any "normal" CR is the prohibition on new starts, i.e., any changes to the FY16 program, e.g., starting construction of a new ship. We count it as highly probable that soon after inauguration either candidate will come out with a strong stimulus package to be included in the FY18 package for Congressional consideration next spring/summer.
