Budget Breakdown

At least one Wall Street analysis firm is predicting that one-third of the proposed budget deal hammered out on Capitol Hill over the past weekend could be made up of defense-spending cuts over a 10-year period. According to a just-released research note from Credit Suisse:

Defense Cuts are a Big Part of the Solution: The proposed budget deal incorporates two tranches of spending reductions, and defense takes part in both. Ultimately, defense could total around one-third of the total spending reduction over the ten-year period.

*      Tranche 1: The initial spending reduction of $900B includes a defense cut of $350B over 10 yrs ($35B or 6%/yr if linearly applied), which is below the President’s $400B request and far below the Senate's request of ~$1T. At first this appears bullish, but is more onerous once Tranche 2 is considered.

*      Tranche 2: The 2nd reduction is $1.5T (the 2 tranches add to $2.4B). These cuts are scheduled to be allocated by a joint Congressional commission by Nov. 23, 2011 (following broader House & Senate direction in late Oct). The committee will have 12 seats, 6 each from the House & Senate, divided equally between the parties. Given concern that the Commission could stalemate, there is an Enforcement Mechanism (or default Tranche 2 plan) to motivate all sides to come together.

*      Contingency Plan: If the committee stalemates, the enforcement mechanism triggers on December 23, and directs that beginning in FY13, there will be $1.2T in automatic cuts, divided equally between domestic and defense spending. White House guidance indicates this plan, if triggered, adds ~$500B in additional DOD cuts (for FY13 and beyond) to the $350B from Tranche 1. That total, approaching $850B over 10 yrs, is slightly closer to the previous Senate plan ($1.1T for DOD) than either the prior Republican (~$300B) or White House ($400B) plans.

*      Ultimate Outcome Likely Middle Ground: In sum, we see an outcome closer to $850B than $350B as the former is the default position everyone will negotiate from in Dec. We expect a final amt of $700-$850B, for a middle ground between the Boehner and Reid plans, which appears slightly more bearish than investor expectations from last week.

*      Procurement Account Will Bear the Brunt, at Least Initially: Given the inflexibility of the DoD to immediately reduce force structure, the majority of DOD cuts are likely from procurement in FY’12 & FY’13. The "roles and missions" review will identify specific program cuts and is expected in early October. We suspect Def Sec Panetta to essentially reverse engineer the cuts in the study to the new top-line funding levels from the debt deal.

*      Sector Impact: While some may feel visibility increased incrementally today, we see a continuing overhang on defense stocks until Tranche 2 comes into focus.

Inside the Pentagon reported last month that DOD has been looking at cuts much deeper than the $400 billion President Obama seeks to strip from security spending over the next decade.

Vice Chairman of the Joint Chiefs of Staff Gen. James Cartwright told reporters at a July 14 breakfast in Washington that DOD wants to understand the effects of steeper cuts should they become necessary. Further:

Although Cartwright said the Pentagon has not been told to prepare for anything greater than the $400 billion through FY-23 that Obama laid out in the spring, he said that "you're most worried about a deeper cut."

Greater defense spending reductions have been discussed by lawmakers and the White House as they debate long-term budget cuts.

"You want to understand that if you go beyond that target, what are the implications that you've done something in the current target of $400 billion that would disadvantage the department or the capability . . . if you took one more cut?" Cartwright said. "So we're doing due diligence on that."

The budget drills were self-initiated, Cartwright said.

The department has "three buckets" it can cut from, Cartwright noted. The first bucket involves readiness and operating costs for the next three years. The second, which is aimed at spending four to six years into the future, deals with force structure. To make cuts in this arena, DOD can change the balance of the active-duty and reserve forces. "Those are all different characters and they have different costs that you can manage based on time when you bring those forces into theater," Cartwright said.

The third bucket, which starts more than six years out, deals with infrastructure and entitlements, Cartwright said.