We are changing our optimistic view of the prospects for long term real growth in the Pentagon budget and now believe that the deal about to be struck for FY 2018 will be the high water mark in defense spending for several years. The sun will definitely shine for defense contractors for the next two years but less so after FY19.
Since the Budget Control Act (BCA) forced a cut of $35B (6.6%) in the Pentagon's baseline budget in FY13 compared to FY12, Congress has biannually increased baseline spending so that in FY17 it was within ~1% of the FY10 high water mark of $528B albeit with 12% less buying power. Some of the reduced buying power has been mitigated through much greater use of Overseas Contingency Operations (OCO) funding to which the BCA caps do not apply. Compare the $163B in OCO funding appropriated in 2010 to support ~200K troops in Iraq/Afghanistan to the $83B in OCO funding appropriated in 2017 to support less than 10% of that number, ~19K troops, in Iraq, Afghanistan and Syria today.
The final budget numbers for FY18 and 19 are still hostage to the ideological struggles over immigration policy and non-defense spending parity now underway. Numbers are unlikely to be final until ~ 16 February after yet another Continuing Resolution that caps funding at FY17 levels. While the President requested $574B for FY18 (+9.5% to the enacted FY17 level), Congress actually authorized $611B (+16.6%)in the National Defense Authorization Act (NDAA). We believe that when all is said and done in February, the baseline number will be no more than what the Senate Appropriations Committee has previously recommended, $590B (+12% y/y). The chart shows the current status of the FY18 budget request:
The chart below puts the various scenarios (BCA, PresBud, SAC, NDAA) into perspective over time. The PresBud line also reflects the current assumptions being used by the Pentagon in its Future Year Defense Planning for the period FY19-22.
While defense spending looks great through FY19, the chart below shows the huge uncertainty created by the pending two year deal. FY18 looks to be the high water mark (FY19 will be at best flat to FY18). Here's why we're now pessimistic about FY20 and beyond:
- The House seems increasingly likely to flip Democratic this November and the Senate is clearly in play.
- The Administration has made it clear that its FY20 budget proposal has to be more robust than what it is going to propose for FY19 because of its new defense strategy (not to mention that 2020 is an election year!). SecDef Mattis has testified that he must have 3% real growth for the next five years if he is going to restore readiness by 2022. Unless the BCA is again amended, the Pentagon will be on track for a $50B reduction in FY20.
- When the new Congress begins consideration of the FY20 budget (just a little over one year from today!), $1T+ annual deficits resulting from the Republican tax cut will be clearly visible as will the resulting fiscal pressure on entitlements and Democratic non-defense goals. Defense hawks are going to be in a bad place...
