In what is shaping up to be a significant challenge for the United States defense industry, the Aerospace Industries Association (AIA) has raised concerns that the sector can no longer sustain absorbing the costs of inflation without risking its financial stability and modernization initiatives. Eric Fanning, the head of the AIA, has warned that the defense contractors are feeling the squeeze from rising labor costs and the increasing prices of commodities such as titanium, which is causing an untenable situation where companies are forced to assume excessive financial risk.
This development comes as the industry has experienced a surge in demand following the COVID-19 pandemic and heightened geopolitical tensions post-Russia’s invasion of Ukraine. Yet, despite this demand, the industry faces a potential decrease in purchasing power as future contracts and competitions loom, suggesting that the Pentagon might not be able to fund all its modernization priorities if adjustments for inflation are not adequately planned for.
The reckoning may hit a peak in fiscal 2026, Fanning indicated, when the Pentagon is released from congressionally mandated budget caps that have kept increases to a marginal 1 percent in FY25, a rate that does not track with inflation rates. This could result in a stark decrease in what the Pentagon can afford, potentially forcing a reassessment of priorities and budgeting strategies.
The tension between the Pentagon and its contractors is also evident in the criticism from leaders such as Navy Secretary Carlos Del Toro, who has taken issue with companies focusing on share repurchases over capital expenditures and supplier investments. Yet defense companies counter that with inflation and budget caps biting into the Pentagon’s purchasing power, their options to deliver returns to investors are limited.
As a response to these challenges, AIA has proposed legislative actions to bolster supply chain resiliency. These include trade agreements with allies on critical minerals, removing tariffs on key materials like titanium sponge, and reforming the fixed-price contract system that has led to losses due to cost overruns, exacerbated by inflation and rising labor costs. The association suggests prohibiting the Pentagon from ordering more than one lot of items in low-rate initial production under a fixed-price deal and requiring the department to assume the risk of loss on work in progress when classification prevents contractors from obtaining commercial insurance.
Such amendments are not aimed at eliminating fixed-price contracts altogether, as they can be favorable in sectors like space where costs are well understood, leading to higher margins. However, the issue arises when these contracts are enforced too early in the development process before true costs can be ascertained.
The current environment stands as a stark contrast to the ongoing debates over Environmental, Social, and Governance (ESG) factors in investment, where financial firms have faced political pressures resulting in a retreat from formal climate-related commitments. Like the defense industry, these firms have to navigate a complex web of consumer expectations and political scrutiny while maintaining their fiduciary duties to investors.
Relevant articles:
– Tired of being ‘shock absorber’ on inflation, defense industry wants new protections: AIA chief, Breaking Defense
– State AGs and ESG: Political Whiplash for Policymakers and Investment Managers, Brownstein Hyatt Farber Schreck, LLP