Five Reasons Romney Would Be Good News For The Defense Industry

As Hurricane Sandy bore down on the nation's capital this week, many local defense executives were focused on a different kind of storm.  Having long since equipped their homes with generators to guard against the capital region's frequent weather-related power outages, the execs running companies like Lockheed Martin and Northrop Grumman are more worried about the metaphorical budget storm that will befall Washington at year's end.

That looming downpour of legislatively-mandated tax increases and across-the-board spending cuts is so huge that it could cut the government's trillion-dollar budget deficits in half, mainly by raising federal revenues 20% year-over-year.  That might sound like good news for an industry that sells most of its goods to the government, but another facet of the impending changes is two trillion dollars in spending cuts required between now and 2021 by last year's Budget Control Act.  The defense department is supposed to cough up half of those cuts, even though it represents only a fifth of federal spending.

So even though several of the nation's biggest military contractors reported quarterly results last week that beat estimates, their stocks are battling fears that defense demand is about to fall off the fiscal cliff.  The outlook isn't really that bad -- any military cuts would phase in gradually -- but there is a more immediate reason to suspect that the defense industry is going to do fine in the years ahead.  That reason is President Romney.  If the Republican presidential candidate is elected, indications are that fears of flagging military demand will prove unfounded.  In fact, the defense sector could end up outperforming the rest of the economy, just as it did in the last decade, given how impending tax increases are likely to impact commercial activity.

You don't need to do deep analysis to arrive at this conclusion.  Just look at what President Obama has done on defense since taking office four years ago, and compare it with what Romney says he would do.  Then look at how past Republican administrations have funded defense, and what Republicans believe about the role of government.  It isn't hard to construct a case that concerns about a big downturn in defense have been overdone.  That doesn't mean I think you should vote for Romney -- personally, I'm voting for Obama -- but if Romney prevails, it looks like the defense sector will be in good shape compared with, say, housing or autos.

Obama's Defense Record.  President Obama won the White House by running against an unpopular war, and once he occupied the Oval Office he quickly delivered on campaign promises to change Pentagon priorities.  By the administration's own admission, its main focus in reducing military spending during its first two years in office was to trim weapons programs, which resulted in the elimination of hundreds of billions of dollars in planned outlays.  The Pentagon also "insourced" tens of thousands of service jobs previously performed by contractors, and launched a series of efficiency moves that squeezed industry profits.  When these management initiatives are combined with the president's efforts to extricate U.S. forces from overseas wars, the cumulative impact on defense-industry fortunes is decidedly negative.

There is little reason to suspect defense trends would change in a second Obama Administration.  After unveiling its so-called Asia-Pacific strategy at the beginning of this year, the Pentagon then proceeded to slash naval shipbuilding plans and funding for its longest-range surveillance drone -- efforts that logically should be at the center of any Pacific strategy.  Candidate Romney overstates the case when he blames Obama for the trillion dollars in defense cuts mandated by the bipartisan Budget Control Act, but the legislative history clearly demonstrates that Democrats tried to leverage the threat of big military cuts to win tax increases from Republicans.  That approach underscores the relatively low priority the administration assigns to maintaining military spending, compared with expanding social-welfare programs.

Romney's Military Views.  Candidate Romney has repeatedly stated that he intends to roll back planned military cuts, increasing defense spending from its current 3.5% of gross domestic product to "a floor of four percent of GDP."  That would require an increase of about $2 trillion over ten years in projected military budgets, and Romney's surrogates have gone into some detail in laying out how the money would be spent.  Among other things, the Republican candidate would increase the pace of naval ship construction from nine vessels per year to fifteen, providing a major windfall for shipbuilders General Dynamics and Huntington Ingalls Industries.  Romney would also bolster missile-defense efforts, push ahead with production of Lockheed Martin's F-35 fighter while keeping Boeing's F/A-18 Super Hornet fighter in production (Obama plans to end production in 2014), and rethink plans to shrink the Army.

Some Romney advisors tell me that the Governor's views on how big the Army should be are in flux, which isn't surprising given the fact that its current size was dictated by wars that now are winding down.  But that highlights the fact that much of what Romney says he would do in the defense arena involves increases to weapons accounts benefiting industry.  Romney advisor (and former Navy Secretary) John Lehman says the Governor would like to see more competition in weapons purchases and less bureaucracy; competition necessarily requires increasing current levels of weapons production, and the notion of cutting bureaucracy is music to industry's ears.

Romney's Foreign Policy.  Military forces exist to defend the nation and pursue national objectives overseas.  Thus, the goals set forth in the nation's foreign policy dictate how big and capable the defense establishment must be.  President Obama has spent much of his tenure scaling back how America defines its overseas role.  In addition to putting overseas military campaigns on a timetable for completion, he has taken a restrained approach to civil wars in Libya and Syria while favoring economic sanctions over military action in seeking to block Iran's pursuit of nuclear weapons.  He also plans to transform the global war on terror into a low-profile effort relying mainly on the intelligence community and special forces.

Candidate Romney has set a more aggressive tone for his own foreign policy.  He says the United States faces a "moral imperative" to prevent Iran from obtaining nuclear weapons, which implies military support for any Israeli moves aimed at destroying Teheran's research sites.  He says he would brand China a currency manipulator on his first day in office, signaling a more confrontational approach to dealing with the Middle Kingdom's mercantilist behavior.  More generally, he says the United States must maintain a strong military presence in the Middle East and Western Pacific.  The tone of Romney's pronouncements on foreign policy implies the kind of increased tensions that will lead to greater demand for military forces -- and the supplies that sustain them.

Past Republican Administrations.  If Romney's views on defense and foreign policy remind you of Ronald Reagan or George W. Bush, that's because his ideas and advisors are drawn largely from those previous Republican administrations.  Although Democrats presided over most of the big military buildups of the last century, it is the Republicans who have favored a more robust national-security posture since the Vietnam War.  Merrill Lynch analyst Ronald J. Epstein captured what this means for the defense industry in a 2006 research note: "Over a span of 50 years, we found that political control of the Presidency, Senate, and to a lesser extent, House are the most significant factors driving defense spending, far more significant than other commonly accepted models such as those based on 'threats' (real and/or perceived) or 'public opinion'."

Epstein found that "a Republican in the White House would lead to an increase in defense spending, while a Democrat in the White House would lead to a decrease in defense spending."  Since Epstein was using the phrase "defense spending" to refer solely to the weapons accounts driving defense-equity valuation, his findings have profound implications for military contractors.  Whether it is Reagan or Bush or Romney, when Republicans control the White House weapons spending increases.  Whether it is Carter or Clinton or Obama, when Democrats control the White House weapons spending declines.  President Obama's priorities and Governor Romney's pronouncements thus fit into a long-term pattern signaling stronger demand for defense-sector products (and stocks) if the Republican candidate is elected next week.

Republican Political Philosophy.  There is one more reason why Romney's election would be good news for the defense industry, and that has to do with the deeply-held philosophical views of the Republican base.  Republicans basically don't believe in the welfare state, but they're quite comfortable with what might be called the "warfare state" because they think national defense is one of the few legitimate roles the founders envisioned for the federal government.  In the old days when the party had an isolationist wing that meant using military forces to keep foreigners out of the Western Hemisphere, but now it means taking the lead anywhere around the world where democracy is threatened.  And unlike Democrats, who are always seeking partners for their overseas ventures, Republicans have translated their belief in self-reliance at home into a willingness to act unilaterally abroad.

Republican political philosophy thus lends itself to support for robust military capabilities even though the base doesn't like other aspects of big government.  That implies, ironically, that defense spending is the main tool beyond tax policy that Republicans have for stimulating the economy.  Few Republicans would favor buying weapons to bolster economic activity, but in the process of sustaining a vigorous defense posture and foreign policy, they end up shoveling hundreds of billions of dollars into places like Denver and Fort Worth that might otherwise be facing more difficult times.  Democrats at the national level have never seemed to grasp the role that weapons spending plays in the economy, but all you have to do is look at the ads Romney is running in battleground states such as New Hampshire and Ohio this week to see that he gets it.

So don't be surprised if the cloud of fear hanging over defense-industry prospects suddenly dissipates after a Romney election victory.  All that time you spent trying to understand sequestration probably was wasted if Mr. Romney wins, because he has already signaled that he will take care of the defense sector.