Defense market should brace for a reality check

It was not too long ago -- around this time last year in fact -- that defense stocks continually reached and breached new all-time highs in hopes of increases in military spending under a Donald Trump administration after years of flat or declining budgets.

Although still optimistic, analysts at Credit Suisse believe the defense sector is due for a slight reality check even with a more favorable budget environment compared to recent years. And they see the budget environment as partly to blame, along with macro factors that include the November midterm elections.

The two-year budget agreement signed in February raised the spending caps for defense and civilian agencies, while the fiscal year 2018 omnibus spending bill signed in March lifted appropriations on both ends for the rest of the government calendar through Sept. 30.

Several chief executives at large government contractors told investors in recent earnings calls that defense agencies will be active in awarding contracts through the end of the fiscal year because they prepared for the increases, but civilian agencies may be slower because they were preparing for cuts.

But in a Tuesday note for investors, Credit Suisse’s analysts point out that the specter of sequestration looms again in fiscal 2020 and thus a return to spending caps mandated under the Budget Control Act, unless Congress forges a new deal.

The odds of a deal would go down dramatically if Democrats retake the House in November, a scenario that mirrors the 2010 Republican takeover of the House.

Credit Suisse sees that as “likely to increase the level of dysfunction in Washington as the House “potentially shifts toward a more obstructionist agenda and compromise becomes more difficult.”

As the analysts pointed out, it took six months of continuing resolutions to get a budget agreement even with the Republicans controlling the legislature and executive branch.

Another continuing resolution may not be so bad from a funding level perspective however as one for fiscal 2019 would continue elevated funds from the fiscal 2018 omnibus.

The Aerospace Industries Association called for the repeal of sequestration in a December letter to congressional leaders. And Lockheed Martin CEO Marillyn Hewson told investors in an April 24 earnings call the prospects of another round of automatic spending cuts loom over industry and the military without a budget deal from Capitol Hill.

If a sequester does come down in 2020, Credit Suisse says to expect reduced procurement spending as part of an 11-percent cut in defense funding.

Keep in mind that sequestration cuts would apply in an equal manner to both defense and civilian agencies.