The Trump Administration's initial defense budget proposal for FY 2020 was better than expected at a nearly 5% increase over the prior year. This growth is even more impressive given the strong increases in the defense budget already seen in 2018-19. We believe this proposal is positive for the defense industry and its equities as it counters recent reports that the defense budget could actually be cut by a few percent as suggested by President Trump this past October. We also believe the defense stocks have been reflecting more of a flat to down defense budget for FY 2020 given the group's valuation contraction during 2018.
We expect this proposal, which also includes a 5% cut in non-defense spending, will likely receive a lot of push back from the Democrats in the House. It's not that Democrats are opposed to a higher defense budget as they have supported prior large increases in 2018-19, they just do not support cuts in non defense spending. It also won't help that a lot of the budget increase is in the Overseas Contingency Operations (OCO) account, which is not subjected to the caps and is typically reserved for combat operations overseas in places like Afghanistan, Syria and Iraq. Given the wind down in operations overseas, we expect it will be more difficult to justify such a large increase in the OCO account. The allocation in the budget of over USD 8 billion to the building of a wall on the US southern border will also get a lot of resistance from Democrats and hamper any eventual budget agreement.
However, even though a budget increase of this size faces an uphill climb in Congress, we believe it is more favorable that the White House is starting from a higher budget level versus an outright cut. This should diminish the likelihood of an outright cut in the defense budget for 2020. We believe given the multitudes of increasing geopolitical risks around the globe, an outright cut in the defense budget is not a likely goal from either political party currently.
We now enter a period of protracted negotiations in Congress that is likely to last most of this year. If there is no agreement by October, Congress will likely approve a continuing resolution, which will be temporary but hamper the funding for new projects and growth and would be a short-term negative for the defense group. The major risk in the medium-term is if there is no budget agreement or a continuing resolution, a process of sequestration would kick in. This process would result in big cuts to both defense and nondefense spending according to the legislation. However, sequestration odds are somewhat low as these cuts are draconian and arbitrary and thus neither political party has the desire to see them enacted. These cuts have only been used once in the past 10 years.
Author: Adam Scheiner, CFA, Industrial and Materials Analyst Americas, UBS Financial Services Inc. (UBS FS)