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Stock Strategist Industry Reports

Budget Deal Boosts Defense

Chris Higgins

Congress and the White House passed a bipartisan budget deal on Feb. 9, which included large increases in defense spending for fiscal 2018 and 2019. Defense stocks are moving up on the news, but we had already increased our fair value estimates after initial reports regarding the deal began to surface. As a result, we still view the sector--including  Boeing (BA),  General Dynamics (GD),  L3 Technologies (LLL),  Lockheed Martin (LMT),  Northrop Grumman (NOC),  Raytheon (RTN), and  TransDigm (TDG)--as fairly to slightly overvalued.

We think defense spending should provide a tailwind to revenue growth over the near to mid-term for the companies we cover, but with profits at all-time highs, we’re not forecasting significant margin expansion. Longer term, we don’t see defense spending going much higher than the top line for fiscal 2019, given pressure from increasing budget deficits. Absent entitlement reform, we think we’ll witness a replay of the 1980s buildup: Despite a strong economy, President Ronald Reagan cut defense spending in the back half of his administration because of high budget deficits.

Most reports are erroneously citing a $549 billion cap for the Department of Defense base budget in fiscal 2018, with total DOD funding under the agreement (base budget plus overseas contingency operations) landing at $700 billion in fiscal 2018. However, the $549 billion figure is for total defense spending that includes agencies other than the DOD. The actual cap for the DOD stands at $525 billion in fiscal 2018 and $537 billion in fiscal 2019. Total funding for the DOD--not total defense funding--will come in closer to $680 billion for fiscal 2018 and just shy of $700 billion in fiscal 2019.

The $680 billion figure is about $40 billion higher than the $639 billion the Trump administration requested for the DOD in fiscal 2018. As a result, the DOD comptroller’s office will need to rework its 2018 budget; we expect this to create a longer-than-usual lag between budgeting and outlays to the industry, particularly on longer-cycle programs. The DOD budget for fiscal 2019 in the bill comports with numbers cited for the yet-to-be released Trump DOD budget request of around $700 billion.

Following tax reform in early January, the Congressional Budget Office began forecasting budget deficits growing from 3.5% of GDP in fiscal 2018 to over 5% of GDP by 2021; this is about a 100-basis-point increase from its previous estimate in June 2017. The average deficit as a percentage of GDP from 1965 to 2017 is approximately 3%. The recently passed increase in federal spending will increase GDP growth slightly and potentially raise more tax revenue, but on net, the additional spending will add to these projected deficits.

Chris Higgins does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.