Over the next month, the White House and congressional leaders will continue jockeying to avert damage to the nation's economy. If they fail to agree on how to handle expiring tax cuts and nearly $1 trillion in government budget cuts by year-end, the U.S. could fall back into recession, the Congressional Budget Office warns.

Before then, however, defense stocks will begin their own decline if investors do not see a deal emerging by Dec. 3, writes Byron Callan of Capital Alpha Partners. And no matter what, it is becoming clear that the Pentagon will not escape further reductions to its budget.

President Barack Obama had an encouraging meeting with the leaders of Congress just before the Thanksgiving holiday. And aides for the White House and congressional leaders are still talking. But even a bare-bones agreement that would prevent the automatic budget cuts known as sequestration and buy time for Congress to reach a “grand bargain” deal on taxes and entitlement spending is not assured. Indeed, Rep. Jim Moran (D-Va.), a senior member of the House Appropriations defense subcommittee, put the odds of avoiding sequestration at 50-50.

The impact on defense companies, however, is not likely to engender as much public pressure as reaching a deal on taxes and entitlements—some of the most politically complicated policy issues that lawmakers must resolve. At least at first, contractors are not likely to experience a visible impact, given the delay to 2013 appropriations that has pushed many contract renewals to late summer and early fall.

But the public will begin to feel budget cuts when more tangible reductions are made. “If you want to generate support for the federal government, just try furloughing air traffic controllers for a month, or meat inspectors,” Moran says. “If Republicans want to insist upon going through with this sequester and not adequately compromising with the president, I think it's going to come back to bite them.”

One defense analyst's worst fear is that sequestration will take place but that defense cuts will be fairly painless in the early months, since it will take time for the government to implement the penalty and furlough employees.

If sequester actually happens and by February there's “no blood on the floor,” Congress might opt for another bad deal, says David Berteau, director of the International Security Program at the Center for Strategic and International Studies. “That, to me, is the scariest scenario of all . . . that Congress says it's not so bad, let's do it again.”

A grand bargain on taxes and entitlements remains the most permanent way to avoid such pain. But that still would mean tighter purse strings at the Pentagon. “I see no scenario in which the Defense Department isn't also in line for cuts,” Berteau says. At a minimum, that could mean an annual reduction of about $30 billion per year. “The benefit could be that it's not all [happening] right now.”

Wall Street might go along with a $30 billion annual reduction to defense spending if that was part of a larger agreement on taxes and entitlements, Callan notes. But yearly reductions of $50 billion or more “would likely prompt a negative defense stock reaction,” he writes in a note to investors.

Left-leaning think tanks in Washington are already looking at what choices a more substantial defense budget reduction would require. One of them, a recent report by the Stimson Center, looks at a “smoothed sequester” scenario calling for $550 billion in defense reductions over 10 years beyond what Obama asked for in fiscal 2013. The report advocates a strategy called “strategic agility” that prioritizes space, air and naval forces and could be executed under those budget constraints, it claims. If the Pentagon could find $400 billion in “efficiency” savings, which includes tackling military entitlements, it could make up the remaining $150 billion with cuts to Army and Air Force force structure, theater missile defense and nuclear forces.

Others in industry have already predicted a grand-bargain deal leading to about $750 billion total in cuts to defense growth, halfway between existing cuts and the total undersequestration.

In the Line of Fire
Left-leaning think tanks have issued recent reports suggesting ways to trim the Pentagon’s budget. They have advocated cuts to these programs to reduce the nation’s deficit:
F-35 Joint Strike Fighters
F-16 Squadrons
B-1 Bombers
Nuclear Arsenal
V-22 Osprey
Aircraft Carriers
Attack Submarines
Littoral Combat Ships
Sources: Project on Defense Alternatives,
Stimson Center, Center for American Progress