Certainty in an Uncertain Age: Sponsored Content
We live in perilous times. The COVID-19 pandemic has precipitated an unprecedented international economic contraction. A World Bank report in June called the COVID-caused global recession the most far reaching since 1870.
In particular, the defense sector faces an uncertain future. The pandemic is threatening to change the way Americans think about security and raise questions about U.S. defense spending—which significantly exceeds the combined defense budgets of all its adversaries.
Many companies will face challenges. One factor that will distinguish the winners from the losers is the financial flexibility to seize M&A opportunities; invest in new, profitable lines of business; and keep teams with valuable and hard-to-replicate skillsets together through tough times. Even more critical is the ability to have a diversified business that is resilient enough to weather any storm. A business with a well-diversified customer base and product offering is likely to hold up better than one that is overly reliant on a small handful of customers or a product that is seeing limited demand, such as commercial aerospace. Also benefiting are those with strong ties to mission-critical defense and government service contracts/customers where supply and demand has seen less of an impact from current circumstances.
Below the surface of events, powerful political, geostrategic and technological currents determine the course of the future. Divining those currents, and anticipating their outcome, is the key to survival for businesses in the new post-corona era. That’s where Regions Securities can help. Offering both investment and corporate banking, Regions Securities’ has a dedicated team with deep knowledge about the sector’s dynamics and challenges, and who can deliver a comprehensive range of strategic advisory, capital raising, risk management and financing solutions that are tailored to help meet each company’s strategic and financial objectives.
Defense budgets “flat at best”
The defense budget will be effectively flat at best over the next three to five years, predicts Steven Adams, a director in Regions Securities’ Defense, Aerospace and Government Services Group. Even before the pandemic, the Department of Defense’s own budgetary predictions were based on annual increases of only 2 or 3 percent—just about enough to keep pace with growing costs. It’s a far cry from the double-digit annual growth in defense spending in the decade after September 11. And those predictions were made before Congress racked up $2 trillion—with a ‘T’—in emergency spending this year to stimulate the coronavirus-ravaged economy, provide a safety net for the millions thrown out of work and help states pay for the massive public health effort.
Doubling the size of the federal deficit overnight is a good way to focus everyone’s mind on the need for fiscal discipline, notes Adams. “These levels of deficit spending have historically brought fiscal conservatives out of the woodwork,” he says.
A flat budget, Adams says, is going to leave DoD leaders “juggling their different priorities”—modernization, maintaining end strength and readiness, and carrying out continuing overseas missions, notably in places like Afghanistan and the Middle East. “The key to all of this is the 2018 National Defense Strategy, and the priorities it set,” he explains. The strategy placed modernization at the center of the DoD’s efforts to counter resurgent competition from great power rivals like Russia and China.
That needed modernization underlies the U.S. military’s commitment to a new generation of technology like Joint All-Domain Command and Control, or JADC2, a new long-range bomber and the development of a new class of hypersonic missiles.
But in a flat budget environment, modernization and recapitalization efforts like that have to be paid for by cutting back spending elsewhere. And the problem is that defense leaders can rarely turn their spending supertanker as quickly as they need to. Retiring legacy weapons systems and closing unneeded bases are often politically unacceptable to lawmakers.
“Something will have to give,” Adams predicts.
If DoD leaders want to protect key modernization programs, “They’re going to have to figure out ways to divest those legacy systems faster than previously planned,” he explains. Retirements like the A-10 Warthog, the B-1 bomber and the oldest of the Ticonderoga class missile cruisers, may likely be brought forward.
Another way to protect modernization programs is to pare back planned spending on big ticket current items. The F-35 is “a major cost driver” so purchasing fewer of them is “certainly a possibility.”
Some Democrats favor major defense spending cuts
But a flat defense budget for the next three to five years is “the best case,” Adams adds. “The really smart money is probably on cuts. There’s a history of defense cuts when deficits get too high.”
With some analysts predicting a “blue wave” in November, driven by opposition to the president, there’s some concern among industry observers that a newly progressive Democratic majority might slash defense spending.
“I don’t think in spite of any of the rhetoric that you’re going to see anything dramatic with the defense budget,” says Greg Jones, managing director and head of the Regions Securities’ Defense, Aerospace & Government Services Group.
Even a Democratic trifecta in November would still leave the Senate narrowly divided, Jones notes. And political gridlock is likely to protect the defense budget. “The reality is that the easiest things to cut are the things that we can least afford to cut—like operations and maintenance, readiness and training. The biggest dollar items are end-strength and the legacy systems. And those are the ones that are most politically difficult to cut because of the impacts across congressional districts all over the country,” Jones says.
When it comes to canceling big ticket DoD programs, “The political will question is a major stumbling block,” Jones points out.
Even a program considered at high risk from a Democratic-controlled Congress, like the modernization of the U.S. nuclear deterrent, is tough to cancel outright, he argues, and modest cuts are unlikely to get the traction they need in Congress. If you rule out canceling major programs, what’s left is “a billion here on this program, a billion there on that … Given the multitrillion dollar budget deficit situation, cutting $20 or even $30 billion from the defense budget doesn’t move the needle and is politically difficult. So it very well may not happen,” Jones concludes.
In any case, he argues, whoever wins the election, the National Defense Strategy laid out in 2018 by then-Defense Secretary Gen. James Mattis, USMC (Ret.), reflects the nonpartisan consensus of the nation’s defense establishment. “That strategy trumps, no pun intended, any potential change in administration,” he says. Whoever wins the election, they will know what the military thinks. They will understand the importance of modernization and of transformative efforts like JADC2
Winners and losers in future defense budgets
A flat budget environment and the emphasis on modernization will create winners and losers among the military services, Adams says, although it’s hard to know for sure right now who will end up in which camp.
“It’s a very fluid environment,” he says. Much depends on which service proves most adept at selling their budget strategies on the Hill. “Still,” he adds, “I think perhaps the Air Force may be primed to do the best here.”
The Air Force—along with the Navy—is also best positioned to start deploying the next-generation weapons systems that will get funding as modernization priorities, Jones argues.
“If you look at the technology most likely to emerge from the hype cycle as a real capability, to me it’s autonomy,” he says. “That combination of unmanned, which we already have, and AI, which we are working on really hard, I think that’s where the future arrives.”
Although there are Army projects to produce autonomous vehicles, “to me the most tangible and most near term, true blending of unmanned and AI would be with the Navy and the Air Force,” Jones says.
Pivot to Asia
The continuing pivot to Asia, underlined by the 2018 strategy, also highlights the role of the Air Force and the Navy, Jones adds, in a theatre where force projection into areas contested by near-peer competitors would be crucial.
The shift of emphasis in U.S. defense spending to the Indo-Pacific theatre is one of the deep currents flowing below the surface of events. But even those currents can be disrupted from the surface, if the event is significant enough.
“Let’s not forget that the enemy also has a say,” points out Adams, recalling the old adage that no plan survives contact with the adversary. “The political conversation is one aspect of it, but you know, the
global threat can certainly always change that conversation.”