BB&T Capital Markets senior equity analyst and vice president Jeremy W. Devaney was one of the first observers to warn that budget sequestration would probably be implemented as mandated in last year’s Budget Control Act. In this assessment for the Early Warning blog, Devanvey explains the political dynamics likely to block efforts at amending the law before sequestration takes its toll on domestic and defense programs in January.
Sequestration on the Horizon. Since early December we have been pointing to the election year political environment as the major impediment to rolling back sequestration and we remain unconvinced that the political environment exists to change the current legislation. Now that the President’s 2013 budget request has been submitted to Congress, it is up to the House and the Senate to craft legislation creating enough budgetary savings to offset the mandatory budget cuts scheduled for implementation on January 2, 2013. Despite what would appear to be a mandate for bipartisan cooperation, Congressional leadership has yet to offer a budget alternative that would avoid sequestration, in our opinion. To the contrary, the House Budget Committee Chairman, Rep. Paul Ryan, submitted a GOP budget proposal that some Congressional Democrats have described as a “nonstarter” due to its emphasis on entitlement reform and tax-cuts while excluding further defense cuts. The factions are aligning as we have previously described and we believe that as the federal budget debate continues and the November elections draw near, the players will only grow increasingly entrenched and less willing to negotiate.
Congressional Rollback Efforts to Date. While initial Congressional efforts focused on pinning a sequestration rollback to the payroll tax cut extension in December, January, and February, the passage of the 2012 payroll tax cut extension on February 17 removed that bargaining chip from the table. Over the same timeframe, Rep. Howard “Buck” McKeon and Sen. Jon Kyl introduced similar but separate pieces of legislation in the House and Senate titled, “Down Payment to Protect National Security Act” (H.R.3662/S.2065) which utilizes a combination of federal civilian pay and hiring freezes to generate $127B in budget savings over an undefined number of years. It is their hope that the $127B in targeted savings will be accepted as an offset to the first year of sequestration thereby effectively delaying full sequestration implementation until January 2014.
One issue we see with both of these pieces of legislation is that the $127B in savings no longer occurs in 2013 but has been stretched over an undefined number of future years which forces observers to question whether the savings are achievable and what the true net present value of the savings should be. Simple math tells us that by stretching the targeted savings over a number of years the net present value will be lower than the Budget Control Act’s sequestration target of $127B in 2013. To date there has been little action on these bills, although we would note that the House version now has 71 co-sponsors – all of which are Republicans and almost half of which have been added since February 1.
Separately, there has been widespread discussion on Capitol Hill seeking to empower Secretary of Defense Leon Panetta with the authority to allocate funding reductions in a more pragmatic manner than the mandated pro-rata application across all budgeted programs.
Overshadowing the Congressional delegates’ efforts thus far, the House and Senate leadership has shown little support for any of the proposed rollback plans. The President, Speaker of the House John Boehner, and Senate Majority Leader Harry Reid have all publicly stated that they will not support efforts to roll back the sequester; we will caveat this by acknowledging that recent body language indicates that there may be an easing from this hardline view. Despite the proposed legislation and the slight easing in the leadership’s stance, we would caution readers that changing sequestration would take a legislative act from Congress. As such, we are not optimistic that sequestration will be meaningfully changed before implementation on January 2, 2013.
Negotiating with Tied Hands – Deficit Spending and Credit Rating Limit Rollback Options.We believe that the credit rating agencies’ current ratings are predicated on Congress following through on sequestration or passing a wide-sweeping, broad-based fiscal reform package that would generate at least $1.2T in budget savings over the 2013-2021 period. Although we note that we are not debt analysts, commentary from all three major debt-rating agencies would appear to discourage changes to the timing or dollar amount of sequestration.
• S&P – On August 5, 2011 S&P downgraded U.S. government debt to AA+ from AAA, noting that the updated lower rating was based on S&P’s expectation of $1.2T being cut from future years’ government spending by the Joint Committee on Deficit Reduction or through sequestration. The S&P report commented that “more broadly, the downgrade reflects (S&P’s) view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than (S&P) envisioned.” Furthermore, at the time of the downgrade S&P changed its “view of the difficulties in bridging the gulf between the political parties over fiscal policy, which makes (S&P) pessimistic about the capacity of Congress and the Administration to be able to leverage (the Budget Control Act)…into a broader fiscal consolidation plan that stabilizes the government’s debt dynamics any time soon.”
• Moody’s – On November 23, 2011 Moody’s Investors Services announced that it was maintaining its Aaa U.S. government debt rating but cautioned that “while a change in the composition of the spending cuts would not be a major rating consideration, a reduction in the total amount…could have negative rating implications.”
• Fitch – On November 28, 2011 Fitch announced it was downgrading its outlook on U.S. government debt to negative from stable while maintaining its rating at AAA. Additionally, Fitch commented that its outlook was based on the agency’s “declining confidence that timely fiscal measures necessary to place U.S. public finances on a sustainable path will be forthcoming…(and that) deficit reduction will not be credible if it relies solely on further cuts in discretionary spending rather than reform to entitlements and taxation.”
Given these comments, we believe that a change in the composition of the sequestration is the only alternative the debt rating agencies may permit without triggering a U.S. government debt rating downgrade. Delays or single year budget patches may be frowned upon by the ratings agencies under the premise that short-term fixes are displays of governance failures, poor policy, or weak fiscal discipline – all items of risk called out by S&P when they downgraded the U.S. debt in August 2011. Additionally, although not explicitly stated by any of the credit rating agencies, we are assuming that the rating agencies are defining the targeted $1.2T in budgetary savings as the net present value of the future years’ savings of the Budget Control Act, as that was the basis of calculation utilized by the CBO. In other words, based on the time-value of money, planned for budgetary saving that are unrealized or delayed will require larger savings to be generated in the out-years in order to meet the $1.2T hurdle. Based on this assumption and the rating agencies’ statements, it would appear that the agencies will have little tolerance for anything other than follow-through on prescribed plan as outlined in the Budget Control Act.
Rollback Players – Entrenched Factions at the Negotiating Table. Changing the composition of the sequestration cuts will be nearly impossible, in our opinion. In support of that statement we would point to Congress’ record, especially when tasked with highly critical issues such as: 1) passing a federal budget (no federal budget resolution has passed Congress since 4/29/09); 2) negotiating a debt ceiling hike; or 3) extending the payroll tax cut (what passed in February was a one year extension). We think that Congress’ performance anxiety will only be exacerbated by election year politics – here is the scenario:
• Defense Hawks strongly support changing the sequestration cuts to dampen the impact on the DoD budget. To accomplish this without triggering another debt downgrade, they propose easing into the cuts rather than having the budget “fall off a cliff.” This would be done by eliminating portions of the 2013, 2014, and 2015 defense cuts and offsetting these cuts by finding savings in “social safety-net programs” as well as cutting transportation, education, and environmental funding.
• Social Welfare Hawks strongly oppose any cuts to the “social safety-net” and have been vocal advocates for increased taxation to reduce deficit spending. Additionally, we believe that in an election year, there would be an increased reluctance by members of Congress to implement changes to social welfare programs. This could go one step further: a large number of Congressional delegates may be fearful of being branded as “against” the poor and working class, resulting in an unwillingness to even take up legislation that would alter social welfare programs.
• Deficit Hawks strongly support budget cuts, period. Although not strictly in favor of defense cuts, during the Joint Committee’s negotiations in November many of the Deficit Hawks were resigned to accepting sequestration as a means of cutting the budget without raising taxes. This group, mostly composed of Blue Dog Democrats, Tea Party members, and staunch fiscal conservatives, could be the swing votes that allow the composition of sequestration to change, but we view it as unlikely. In an election year, we believe these Deficit Hawks would be eager to campaign on their records of fighting government spending and would reluctant to be associated with rolling back any federal spending cuts.
So with two groups, Social Welfare Hawks and Deficit Hawks, viewing inaction as a politically expedient path towards re-election in November 2012, we do not believe the political environment exists to change the composition of sequestration. Our view has only been bolstered by Rep. Paul Ryan’s GOP 2013 budget proposal which many political pundits have characterized as the Republican’s attempt to crystallize their differences with the current Administration and the Democrats in Congress. In our view, the opportunity for bipartisanship may have passed and Rep. Paul Ryan’s proposal could mark the beginning of the election year ideological entrenchment.
The “Lame Duck” Rollback – A Low Probability Scenario. The Defense Hawks are holding out hopes that there may be a path to sequestration rollback during the “lame duck” Congressional session following the November elections. We see this as highly unlikely because Congress would be required to pass the legislation through the regular order business, opening the bill to debate, filibuster, and amendment. The House Majority business calendar currently has only three weeks scheduled between the Thanksgiving recess and the winter holiday recess, given the complications of legislative due process we give the “lame duck” rollback scenario a very low probability of success.
Two items to we would urge readers to consider when evaluating the possibility of success for a “lame duck” rollback scenario:
1) Various DoD officials have publicly commented that a soft shutdown type process will begin on designated programs in early December with a hard stop or full reduction of work-rate taking place January 2, 2013. Meaning that even if a “lame duck” rollback were enacted, it could possibly come too late to avoid the consequences of full sequestration.
2) The risk of full sequestration will rise as January 2, 2013 approaches and the DoD program offices will adjust their spending habits in preparation for sequestration. In comments to us, some officials have acknowledged that funding delays resulting from the risk of sequestration have been and will continue to be similar to, if not worse than, the delays witnessed under budgetary continuing resolutions.
Net/net, we see a “lame duck” rollback scenario as highly unlikely and should Congress wait until the last possible moment to implement a rollback, the consequences of sequestration may already be taking effect.
Is There Any Chance Sequestration can be Avoided? We Don’t Think So. In summary, over the last several months, certain members of Congress—including Sen. John McCain, Sen. Lindsey Graham, Sen. Jon Kyl, Rep. Eric Cantor, and Rep. Buck McKeon—have explored possible alternatives in the proportioning and timing of future cuts. These proposals may be ineffective because we believe that the credit rating agencies’ current ratings are predicated on Congress following through on sequestration. Thus it would appear that a change in the composition of the sequestration is the only alternative the debt rating agencies may permit without triggering a U.S. government debt rating downgrade. Lastly, we believe inaction may be viewed as the politically expedient path towards reelection in November 2012, thus we do not believe the political environment exists to change the composition of sequestration. In our view, these contributing factors will ultimately culminate with the DoD facing imminent sequestration cuts on January 2, 2013.
About BB&T Capital Markets:
BB&T Capital Markets is a full-service investment banking firm that focuses on specific industries, including the Defense industry. BB&T Capital Markets is a division of Scott & Stringfellow, LLC FINRA/SIPC. Scott & Stringfellow is a registered broker/dealer subsidiary of BB&T Corporation, one of the nation’s largest financial holding companies with $175 billion in assets.
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