If Passed, Budget Deal Would Avoid Sequester and Boost Defense

Jesse Frehling | 11-23-2015

JF_cropPerhaps the most significant domestic political development of late was the federal budget deal between Congress and President Obama. The deal, which was struck in late October and must be finalized by December 11 to avoid a government shutdown, will increase federal spending by $80 billion over the next two years, not including an additional $32 billion in overseas contingency operations funds allotted to the Pentagon. The deal was passed with the overwhelming support of Democrats and just 79 Republican votes. Republicans are now trying to attach a number of riders to the budget on matters such as Syrian refugees, Planned Parenthood funding, and financial industry rules. But Democrats will never vote for such measures, and the budget needs Democratic support in order to pass. Newly elected Speaker of the House Paul Ryan (R-Wisconsin) is doing his best to convince rank-and-file Republicans to vote for the budget in its current form and avert a shutdown. Speaker Ryan has enjoyed support from Republicans thus far, and even those on the far right say he is more willing to listen to their views than his predecessor John Boehner. The budget deadline may need to be extended to December 18 or into January. Ultimately we think Republicans will fall in line with Speaker Ryan, but a shutdown should not be ruled out.

Assuming the budget passes, a big takeaway is that the Pentagon received nearly all the money it requested – a big win for defense. Rep. Mike Turner (R-Ohio) had called for a budget that “fully funds defense” at $612 billion. The agreed upon budget deal funds defense at $607 billion. “This is as close to the ‘full bull’ case as you can get,” said Roman Schweizer of Guggenheim Partners. This reverses a decline in US defense spending as numerous geopolitical events have dramatically altered the global security landscape. Islamic State (ISIS) has destabilized the Middle East and its effects have spilled over into North Africa and Europe, most recently manifesting in the devastating terror attacks in Paris. In light of the Paris attacks, France has also reversed a policy to shrink its defense budget in the coming years. Applications to enlist in the French Army have quintupled in the three weeks since the attacks, and the French Army will take on 10,000 new recruits this year and 15,000 more next year. French Finance Minister Michael Sapin says military spending will rise by $635 million next year to finance new operations and equipment. British Prime Minister David Cameron announced his country would also reverse policy of shrinking its defense budget – he pledged to increase defense spending by $18 billion over the next decade.

Global policymakers are starting to realize that defeating ISIS will require a lot more firepower than we are currently deploying. Limited airstrikes may have succeeded in eliminating al Qaeda’s leadership, but ISIS is a different animal. ISIS must hold territory for its caliphate to remain legitimate in the eyes of its supporters. While airstrikes might contain ISIS, they are unlikely to break its hold on territory it already controls. Although Western countries remain hesitant to put boots on the ground in the Middle East after the Iraq debacle, these policy shifts by the United States and Europe’s two largest military powers show that either a dramatically intensified air campaign or ground forces will be necessary to defeat ISIS. Calls for a stronger military response to ISIS will only grow louder if more attacks are carried out on Western soil.

ISIS is not the only security threat that could prompt Western countries to spend more on defense. Russia’s invasion of eastern Ukraine has ignited concerns that Vladimir Putin aims to reassert Russian power, potentially threatening NATO members on Europe’s eastern front. An attack on any NATO member would require the United States to abide by NATO’s Article V and defend that member country. In response, the US is encouraging all NATO members to spend at least 2% of GDP on defense. Only 5 out of 28 member countries were hitting that target as of June, but more are buying American weapons to protect themselves against Russia. As of September, international military orders were on pace to surpass last year’s number of $34.2 billion by $10 billion this year, according to International Business Times.

As it relates to the 2016 US presidential election, the election of a leading candidate in either party will almost surely mean a heightened focus on defense issues. Former Secretary of State Hillary Clinton recently advocated an “acceleration and intensification” of President Obama’s strategy to combat ISIS. Although Clinton is loath to alienate her base by overtly criticizing Obama (and possibly reminding Democrats that she voted to invade Iraq in 2002), she would likely take a stronger stance against ISIS. Leading Republican candidates almost certainly would too.

The most recent poll averages show Donald Trump leading the Republican field by a wide margin in each of the early nominating states except Iowa, where a recent Monmouth University poll shows Ted Cruz leading Trump by 5 percentage points. Cruz has made rapid gains in Iowa by connecting with the state’s large evangelical population and branding himself as the Republican Party’s “insider-outsider” – an experienced politician whose values align with outsiders Trump and Ben Carson. Cruz may be positioned to pick up supporters of Trump and Carson should those two candidates fade, potentially making him a frontrunner for the Republican primary. Indeed, Carson has already begun to slip in the polls while Cruz has picked up steam. As the champion of the far right, Cruz has increasingly sparred with Marco Rubio, who is starting to become the Republican establishment favorite as Jeb Bush has failed to inspire thus far. In early November, Rubio secured the backing of hedge fund billionaire Paul Singer, who was aggressively courted by multiple Republican candidates. Rubio and Cruz are jockeying for third place in many states’ primary polls, behind Trump and Carson. PredictWise, a prediction markets website, gives Rubio a 43% chance to win the nomination, leading Trump (22%) and Cruz (15%). PredictWise gives Hillary Clinton a 93% chance to win the Democratic primary and a 57% chance to win the presidency.

The opinions and forecasts expressed are those of the author, and may not actually come to pass. This information is subject to change at any time, based on market and other conditions and should not be construed as a recommendation of any specific security or investment plan. Past performance does not guarantee future results.

An investor cannot invest directly in an index. The S&P 500 Index is an unmanaged index considered representative of the U.S. stock market.

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