How the Fiscal Cliff will Deal a Blow to U.S. Defense Industry

The fiscal cliff is taking down more than U.S. taxpayers - it will tear through the U.S. defense industry.

At the end of this year, current tax policies are set to expire and new ones will go into effect at the start of 2013. What Americans can expect if the policies are not extended is a painful combo of tax increases and spending cuts that will thrust the struggling U.S. economy back into a recession.

If U.S. lawmakers fail to act, scores of economists agree what we'll get is a $600 billion drag on the already sluggish economy. The tax implications have been widely discussed, but there has been little chatter about the impact on the defense sector, which stands to sorely suffer since it is subjected to half of the proposed spending cuts.

Fiscal Cliff: Wiping Out Defense Jobs

The fiscal cliff, should it materialize, will have a direct and immediate impact on jobs, specifically in the defense sector.

Over the next decade, the $500 billion cuts to defense spending will be phased in, with a whopping $55 billion to take effect next year alone.

The National Association of Manufactures, a lobbying and advocacy group, warned that by 2014 more than 1 million private sector jobs could be eliminated as a result of fiscal restraints. This would result in an uptick in unemployment by 0.7 % and decrease in gross domestic product by about 1%, according to NAM.

Preparing for the spending cuts isn't easy for defense companies. Unlike other industries, defense companies must give workers 60-day advance notice of plant closings and layoffs, according to the 1988 Worker Adjustment and Retraining Notification Act (WARN). That means those workers must be informed on Nov. 2, two days before the crucial presidential election that could mean sink or swim for the sector.

Aeronautics and defense giant Lockheed Martin Corp. (NYSE: LMT) recently cautioned that the bulk of its 100,000-plus workforce risks being laid off due to the lurking federal budget cuts to defense.

Also set to see its workforce shrink and its bottom line hurt are defense contractors General Dynamics Corp. (NYSE: GD), The Boeing Co. (NYSE: BA); United Technologies Corp. (NYSE: UTX) and Raytheon Co. (NYSE: RTN).

Defense Cuts Will Drag for Years

The United States leads the world in defense spending by a wide margin, accounting for almost half of all global spending.

The defense spending cuts will have massive implications across several sectors, not to mention our country's security. And the biggest punch might be felt for a couple years.

"With the U.S. fiscal deficit still an unsolved problem, we remain resolute in our belief that the big cuts in defense budgets have yet to be seen, and may start to show up in the 2014-2015 timeframe after a more turbulent than normal political environment in 2013. We do not expect a major impact from cuts in the defense industry until late in our 12- to 18-month outlook period," Moody's ratings agency noted.

Defense companies are already preparing for the downturn and are expected to downgrade their company forecasts in this month's quarterly earnings calls. The outlooks, however, won't be too specific since so much uncertainty surrounds the industry.

Not Just the Fiscal Cliff ...

With the U.S. military budget set to shrink 25% over the next five years due to spending cuts and as the U.S. continuing to distance itself from conflicts in Iraq and Afghanistan, expenditures for new weapons, research and development programs, and upgrades for older weapons stand to be drastically diminished.

Most Americans agree we don't need another threat to our homeland to beef up or simply maintain our national security. We don't need a reason to defend ourselves. What we need is to have guards in place in the event that we need them.

Until changes are made in national security or spending cuts, investors in defense stocks should be wary of what's ahead in the sector.

If you do choose to keep your holdings, consider some defensive moves with puts or calls.

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