Investors are optimistic, but we see many unknowns.

Chris Higgins is an equity analyst for Morningstar.

New Office of Management and Budget head Mick Mulvaney outlined a base defense budget, which excludes funding for overseas contingency operations, of $603 billion. Predictably, confusion has set in regarding the actual increase the Trump administration is looking for and what this means for the industry. Weve seen reports of a $54 billion increase in defense spending, Sen. John McCain complaining about only getting a 3% increase, and other reports mentioning a 10% increase.The Obama administration requested $552.8 billion in defense spending for fiscal 2017 and planned $586.2 billion for fiscal 2018. Comparing that plan for fiscal 2018 with $603 billion yields a 2.9% increase, hence McCains complaint. The $54 billion figure compares the $603 billion figure with the Budget Control Act of 2011, which caps defense at $549 billion for fiscal 2018. The 10% increase--assuming some rounding--may be referring to either the Trump administrations defense budget increase versus the fiscal 2017 request or the Budget Control Act caps for fiscal 2018, or both.But there are still many unknowns at this stage in the budgeting process. The $60 billion question is the overseas contingency operations account, which is not included in the $603 billion figure. Our sense is that Mulvaney detests the use of the OCO to circumvent Budget Control Act caps, but defense hawks in Congress have proved more than willing to use it as a slush fund for priorities that dont fit into the base defense budget. The fiscal 2017 OCO budget request was $58.8 billion, and its highly likely that the Trump administration will add about $30 billion to this amount via a defense supplemental spending bill. Despite budget hawks distaste for it, we assume that the Trump administration will generate an OCO request as part of the fiscal 2018 budget process, which implies a total defense budget request for fiscal 2018 of well over $650 billion: $603 billion base funding plus our assumption of at least $50 billion in OCO funding. The Democrats in the Senate (the Republicans effectively control the House) can still filibuster the defense budget; in the past, they have typically demanded parity in defense and nondefense discretionary spending increases. Republicans need 60 votes to circumvent a filibuster in the Senate, which means 8 Democrats will need to defect. In 2016, Senate Democrats did not shy away from using the filibuster against the defense spending bill in Congress; this is why the Department of Defense is still operating under a continuing resolution, which freezes funding at the previous years levels and prohibits new-start programs. We think its a distinct possibility that Congress will finally agree on the fiscal 2017 defense budget, but any fiscal 2018 proposal triggers a filibuster and potentially another continuing resolution that can--particularly if it lasts deep into fiscal 2018--create challenges for industry financial performance. Then there is the budget math. The Trump administration and congressional Republicans want to enact sizable tax cuts for corporations and individuals. Trump also continues to push an infrastructure plan, and we note his recalcitrance toward Medicare and Social Security spending reforms. We also note that recent statements from Trump do not emphasize a balanced budget. To offset other priorities, administration officials have pointed to cuts in other discretionary spending as bill-payers for the planned defense budget increase. The administration has put forward a top-line figure for nondefense discretionary spending of $462 billion, which is roughly $100 billion below fiscal 2016 actual levels and about $54 billion below the caps mandated in the Budget Control Act for fiscal 2018. Our view is that most senators and representatives wont find these cuts to other discretionary spending politically palatable and that a comprise will be required. Another wild card is GDP growth. Assuming average real GDP growth of 1.8% annually and no change to current law, the Congressional Budget Office projects persistent deficits of around 3% of GDP through 2020. If annual real GDP growth goes above 3%, then the budget math looks better. But 3% real GDP growth hasnt been achieved in over 10 years, and the longest consecutive stretch in which the real GDP increased by 3% or more each year was 1983-89. Moreover, promises of faster growth in the face of rising budget deficits combined with no entitlement reform may lead to revolt among the 30-40 Freedom Caucus members in the House of Representatives. Although the administrations budget will face hurdles, we view these first broad outlines as an opening gambit to set the negotiating terms with Congress. The next major milestone for investors will be the formal release of the budget request to Congress. Mulvaney is promising to send a budget outline to Congress by March 16 and hopes to flesh out a more detailed budget plan by mid-May. Regardless of timing, we plan to analyze the presidents defense budget request in detail for investors. After the request goes to Congress, it is a long and winding road through committees and ultimately to a possible vote later this year. Again, we think Democrats in the Senate and potentially fiscally conservative Republicans could block spending increases, which could lead to a continuing resolution, effectively freezing the budget at previous-year levels. In the end, this all may be headed toward another bipartisan stopgap measure--Congress has agreed to several in the recent past--that revises upward but does not completely repeal the caps on defense and nondefense discretionary spending. In the interim, we think the fiscal 2017 defense budget that the Obama administration put forward last year might finally get through Congress, albeit seven months after fiscal 2017 started, thereby ending the continuing resolution under which the Department of Defense is currently operating and providing defense contractors with more clarity. We also believe an OCO increase via a separate defense supplemental spending request is likely.

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A Closer Look at Trump's 10% Defense Spending Increase - Morningstar.com