DoD's FY-08 Budget: The Largest in US History

On March 6, Ann Marie Fleming of HomelandDefenseStocks.com interviewed Scott Sacknoff, manager of the SPADE Defense Index (AMEX: DXS). The interview follows:

HDS: We are once again joined by Scott Sacknoff who will give us his thoughts on the FY-08 Department of Defense budget and how investors can take advantage of this. Mr. Sacknoff, thank you for joining us.

SMS: My pleasure Ann Marie.

HDS: The government released its FY-08 budget for the Department of Defense. What did you think?

SMS: Well, unlike last year, which came in stronger than anticipated, the FY-08 budget didn’t present any surprises. Overall, the $481 billion in discretionary budget authority is 11% higher than the FY07 request with much of that increase targeted to the Army and the Marines.

HDS: This is the largest defense budget in American history, correct?

SMS: In absolute, current dollar terms, yes, but this still represents only roughly 4-5% of U.S. GDP. In comparison to years with war efforts, the overall cost to the economy is much smaller, totaling roughly 11.7% in Korea, 8.9% in Vietnam, and 34.5% of GDP during World War II. Imagine the scale of an effort today requiring the output of more than 1/3 of the U.S. economy. So while the ... $481 billion is a significant figure, it is still a tiny fraction of the overall economy.

HDS: With defense spending rising more than 65% since 2001, do you believe this will continue?

SMS: Taking into account supplemental spending on the war, defense sector spending has increased for the last decade. But looking at the core total budget authority, spending from FY05 to FY08 has been relatively flat. If we peer into the details of the budget we see the core budget increasing each year from FY08 to FY13, growing some $65 billion. But there are growing concerns inside the agency that even this may prove to not be enough for the DoD to maintain its current state of readiness. It is possible that we could see further increases down the road as DoD states its case and tries to balance personnel-related costs with meeting its modernization plans.

HDS: …Meaning that spending in defense could rise even in the absence of a presence in Iraq?

SMS: Correct. DoD is facing a number of issues that will add to the cost of its maintaining a state of readiness. First of all, there are numerous personnel-related issues such as rising costs for health care and military pensions. Personnel costs are expected to rise 22% by FY13 whereas the rest of the budget is due to rise only 10.8%. Coming out of our stay in Iraq, we will likely see increased costs associated with recruiting and retaining military personnel as well as increased long-term costs associated with medical and war service benefits. Although it has been discussed, having military retirees pay for a portion of their health-care is seen as political suicide and is therefore unlikely. From an operational standpoint, resources to pay for the war were diverted from a number of programs designed to improve the efficiency and capabilities of the military and enable us to take action while putting people and equipment further out of harm’s way. Many in the military have cited the need for significant reinvestment in equipment and supplies to replace that which has been damaged or worn out. This could be a lengthy and costly activity.

HDS:With public opinion calling for a pullout of Iraq, won’t Congress provide greater scrutiny to future budgets?

SMS: Absolutely, and they will have to find a balance between what is necessary to modernize the military and putting the overall government budget in further balance. It is going to be an interesting challenge for whoever is the next President.

HDS: Looking at the budget and your comments, how does this effect companies operating in the sector?

SMS: Using recent history and the current budget as a guide, there are still a number of positive factors. First of all is the $65 billion in growth in the core DoD budget. While R&D funding shows a slight decline in today’s dollars and a large decline if factoring in inflation, the combination of procurement and RDT&E still shows a $17 billion gain over the next five years. Secondly, there has been an ongoing trend by the military to outsource in the area of operations and maintenance, a budget area due to grow by $24 billion. This reflects a range of day-to-day activities, including skilled positions, where former military personnel working for private contractors work side-by-side or in place of their military counterparts..

HDS: Before we close out, tell us what’s been the effect on defense stocks.

SMS: The year started out strong, likely in anticipation of the early February release of the budget. The SPADE Defense Index continued to reach new all-time highs and the Powershares Aerospace & Defense ETF (PPA) saw inflows of nearly 70%. This of course was stopped short in the last days of February as the world markets declined due to economic issues in China, Japan, and the U.S. real-estate sector – all of which are unrelated to the defense sector itself. But when investors decide to exit markets and take profits, very few sectors were unaffected. Considering the run in defense since the market’s last pullback in May of 2006, the roughly 6% drop is relatively minor taking the Index back to its January levels.

HDS: This has been great. Thank you for joining us today. If you are interested in getting more information about the SPADE Defense Index, please visit www.spadeindex.com. Historical data for the index can be found using the index symbol ‘DXS’.And as always, the information presented in this interview is for information purposes and should not represent a solicitation or an offer to purchase an investment product. Investors interested in the Powershares ETF trading under the ticker ‘PPA’ should visit the powershares.com website for a prospectus.

Disclaimers: The information presented in this interview is for informational purposes and should not represent a solicitation or an offer to purchase an investment product. SPADE and the SPADE Defense Index are registered trademarks of the ISBC. Powershares is a registered trademark of Powershares Capital Management.