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Takeaway: The only way to even a flat Pentagon budget is by holding your nose to the rising stink of the deficit.

While several analysts have opined that the midterm elections will have only limited impact on the probability of Congress and the President avoiding a Budget Control Act-mandated sequestration of discretionary spending in FY 2020, we think it important for investors to appreciate just how tortured that path will be.

To review: The Budget Control Act (BCA) of 2011 as amended establishes discretionary spending ceilings for "Defense" (DoD and most of DoE) and for Non-Defense (everything else) through FY 2021.  The law establishes baseline spending ceilings.  When passed, emergency funding appropriations (Overseas Contingency Operations (OCO) or disaster relief) automatically increase the ceiling by their respective amounts.  Emergency appropriations essentially do not count against the ceiling but they do count towards the US deficit.  Each January (i.e. Q2 of the fiscal year) any appropriations exceeding the ceilings are cut automatically and across the board: funds from every "program, project and activity" are sequestered by an equal percentage. Sequestration famously occurred in 2013 with readiness impacts that have lasted to this day.

 The chart shows the current Budget Control Act ceilings for defense (blue) and non-defense (orange) 2018 through 2021 and the US deficit (red) for the same period (2019-21 estimated).

Tough Neighborhood: Getting a Pentagon Budget Deal - Discretionary Ceilings with Deficit

Source: https://www.whitehouse.gov/wp-content/uploads/2018/08/Sequestration_Update_August_2018_House.pdf

The chart essentially shows the three principal arguments which are not mutually exclusive

  • "Defense spending must remain flat to FY 2019."  Given the Pentagon's looming recapitalization challenges, Defense hawks argue that the step increase in Pentagon spending that was made in the last two year BCA amendment must be maintained.  Until two weeks ago the Pentagon had been preparing a budget for FY 2020 that conformed to a ceiling of $730B, $100B above the statutory ceiling shown with at least $20B in OCO spending.  The President has since said that the Pentagon request would be reduced by $30B but that is still $70B above the ceiling.  See my note "How to Find $30B in the Pentagon Budget."
  • "Non-defense spending must be equal to defense spending."  The original premise of the Budget Control Act was parity between Defense and Non-defense baseline spending. Most of the differences that have emerged between the categories since the original bill are attributable to OCO spending for DoD.  As "overseas contingencies" have generally wound down to a relatively steady state and appear to be going lower, it is virtually certain that restoration of parity will be the bottom line of the Democratic leadership in both houses when BCA amendment discussions begin.  
  • "The US deficit is spiraling out of control and must be reduced." The chart shows that the deficit is not only growing but accelerating relative to GDP.  The 2018 deficit of $779B is 4.2% of GDP while the estimated 2021 deficit of $1.113T is 4.9% (and likely to come in higher given interest rate changes). The chart also shows that we can't there by just squeezing discretionary spending unless we're willing to go to zero with that part of the Federal budget. Fiscal conservatives, who have now gained proportional strength within the now-smaller Republican caucus, are not only dead set against any increase in non-defense spending but are increasingly willing to ask defense to pony up, e.g., the $30B cut being forced on the Pentagon by President Trump.

There are two scenarios that will unfold over the next budget cycle:

  • Amend the BCA: Democrats make a deal with enough Republicans in Congress and the President.  The intent would be to satisfy the first two arguments listed above and generally disregard the third. An infrastructure bill of $70 to $120B to balance a $70B increase to the defense ceiling (plus some OCO) would satisfy a number of agendas.  It would also increase the deficit by something like $200B (20%), increasing the risk of inflation and inviting more interest hikes. A deal offers the attraction of budget stability through the election which both sides think they will win. 
  • Live with the law.  This would be draconian for the Pentagon given that it is $150B (~21%) less than they have been planning (more than five times worse than what Trump has proposed) but it would keep the Republican squeeze on non-defense and keep the deficit to only $1.113T.  The damage to defense could be mitigated by wildly inflating the OCO proposal to $120B or so (only $69B in FY 2019 and planned to be only $20B in 2020) to make up the difference but of course this would increase the estimated deficit and would only cover one year.  Blocking this tactic would give Democrats the dilemma of voting against OCO (almost never done historically) before the 2020 election.  A big drawback for everyone would be the need to relive the whole drama again for FY 2021 just before/after the 2020 election.