Budget Sequestration Could Give Defense Stocks A Boost In 2013

Senior executives at major defense companies are warning that the sequestration provisions contained in last year’s Budget Control Act could produce chaos if they trigger as planned on January 2. The law requires that $60 billion be cut from defense accounts in fiscal 2013 as part of a ten-year package to generate $2.1 trillion in federal savings (see my blog posting of June 6for details). However, nobody at this point knows precisely how automatic cuts will be implemented, so to be on the safe side companies plan to notify workers of potential job losses months in advance of January 2.

Obviously, all the talk about budget cuts at the Pentagon is undermining the appeal of defense stocks. Almost every company in the sector saw its share price decline over the past two months, and most of them declined more than the Standard & Poors index of 500 stocks. However, because sentiment has deteriorated faster than fundamentals, the shares might rally significantly if some sort of catalyst occurs that leads investors to rethink their reasoning.

The most plausible catalyst is a Republican election victory in November, since Republican control of the White House and Senate historically have been associated with surges in weapons spending. But most analysts don’t think a Republican sweep is likely, so even if Governor Romney wins the White House that might not remove the political paralysis that is currently blocking resolution of budget issues. There is another kind of catalyst, though, that could change the outlook for defense shares. That catalyst, paradoxically, would be the triggering of sequestration on January 2. Once that happens, all the uncertainties surrounding the process will gradually be resolved, and the beaten-down share prices of military contractors might look like they have nowhere to go but up.

With everyone seeming to focus on the negative right now, it’s easy to overlook the fact that cuts to budget authority made in 2013 will spread out over several years, reducing the near-term impact on contractors. In fact, it’s possible that the cost-cutting companies like Lockheed Martin and Northrop Grumman are pursuing in anticipation of sequestration will save the companies more money than budget cuts take away. Furthermore, the seating of a new Congress is likely to be accompanied by moves to repeal or amend the Budget Control Act, sending a signal to investors that sequestration isn’t going to last for very long.

That doesn’t mean that implementing sequestration would be a pleasant experience. But right now the fears about what it will do to company results are driving sentiment on defense shares to a greater degree than actual impacts on earnings are likely to warrant. So the catalyst for a change in sector sentiment that many analysts are looking for could come on January 2, when investors realize that dumb and wasteful though sequestration may be, it isn’t the end of the world.