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Government contracting outlook: Fall 2022

Oct 06, 2022

Government contracting outlook key takeaways

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Geopolitical conflict has thrust contractors into the global arena if they weren’t there already.

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The administration’s antitrust concerns could affect contractors’ acquisition pipelines.

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Supply chains are improving, but electronic component shortages remain a problem.

Government contracting Economics

Dynamic factors abroad and domestic require contractors to be agile

Allied nations continue to unify around Ukraine in its war with Russia. As a result, the Pentagon is spending more money in Europe, and NATO allies are signaling increased investment in the cause. Federal government contractors have been thrust into the global arena if they weren’t there already. 

Meanwhile, at home, the legislative branch in August finally passed a bill to boost semiconductor manufacturing investment, and the executive branch is flexing its muscle to protect competition. It’s crucial for contractors to be agile in their strategy and operations, as ecosystem dynamics can change on a dime. 

All NATO hands on deck

International budgets continue to trend up, especially in NATO countries, according to industry executives. “We believe we’re experiencing a sea change in defense spending and priorities with profound implications for the U.S., Europe and our allies both in the short and long term,” said Mercury Systems President and CEO Mark Aslett on an earnings call in May.

A broader response from allies looking to support Ukraine suggests greater international demand in the medium to long term. NATO countries are signaling a renewed focus on their defense spending target—2% of their nation’s gross domestic product—and the alliance welcomed the membership applications of Sweden and Finland in July. The formal accession process is ongoing.

We can start to see industry executives’ expectations coming to fruition in U.S. Department of Defense contract spending data. According to Bloomberg Government, as of Sep. 13, fiscal year-to-date 2022 DOD contract spending in European NATO countries totaled $4.35 billion—greater than 77% of total spending in the prior fiscal year. Given that the DOD’s fiscal year ends Sept. 30, at first glance that figure may seem behind schedule. However, DOD contract spending data has a 90-day lag and typically spikes in the fourth quarter. 

U.S. Department of Defense contract spending in European NATO countries

Bloomberg Government estimates nearly one-third of annual government spending occurs in the fourth quarter, and the DOD has, on average, accounted for 62% of that fourth-quarter surge since 2017. Russia invaded Ukraine in late February 2022; therefore, the latest data set includes only any upticks in spending for approximately four months of a war that has lasted nearly seven. Ultimately, we expect the DOD’s fiscal 2022 total to significantly surpass that of fiscal 2021 once all data is reported.

FY 2022 year-to-date U.S. Department of Defense contract spending in European NATO countries

So far in fiscal 2022, the majority of Pentagon contract spending abroad has been in Germany ($1.9 billion), followed by Greece ($605 million), the United Kingdom ($531 million), Poland ($318 million) and Italy ($250 million). As DOD data continues to be tallied, we expect to see even greater dollar amounts that reflect the United States’ investment in its European presence.

Under extremely challenging circumstances, NATO powers are uniting toward a common goal and demonstrating cross-border collaboration. This will result in U.S. defense contractors being in high demand to serve the United States and allied nations. Those that target both customers may be challenged to meet the innovative goals of the former while supplying older model systems to the latter.

CHIPS for America

Supply chains are improving, but electronic component shortages remain a problem. Limited supply, pent-up demand, inventory imbalances, few substitutes and long lead times continue to throw wrenches into project planning and delivery for many contractors. On top of that, the Pentagon views the microchip shortage as a threat to national security.

Domestic demand so outpaces domestic supply that industry leaders called on the U.S. government to fund the CHIPS (Creating Helpful Incentives to Produce Semiconductors) for America Act as part of the U.S. Innovation and Competition Act of 2021. Advocates of the so-called CHIPS Act suggest it is needed for the United States to compete with foreign countries whose governments have already invested heavily in the market via manufacturing incentives and subsidies.

The House and Senate passed separate versions of the bill in February and June of 2021, respectively. However, Congress took its time producing a reconciled bill for the president’s signature despite the bipartisan support for the initiative. CEOs and trade organizations called on Congress to pass a bill, indicating that was a condition for making significant investments in U.S. manufacturing of semiconductors. A Department of Commerce news release cited such comments made by three companies. The so-called CHIPS+ Act—a package that includes the CHIPS Act and additional legislation—finally received the votes it needed in the House to head to the president’s desk for signature on July 28.

The semiconductor market will continue to grow as defense—and, really, the world as we know it—moves into the digital realm. According to the World Semiconductor Trade Statistics spring market forecast, the semiconductor market will grow 16.3% in 2022 and 5.1% in 2023. 

Semiconductor market totals and forecast

Contractors can take comfort knowing the Biden administration is focused on the issue, as evidenced by an executive order in February 2021 intended to “strengthen the resilience of America’s supply chains.” To that end, the order identified semiconductors and advanced packaging as one of four critical products (the others are critical minerals and materials, large-capacity batteries for vehicles and grid storage, and active pharmaceutical ingredients). However, getting a funded CHIPS Act through Congress proved to be challenging. Contractors should prepare for further lobbying if other issues continue to take center stage at the U.S. Capitol in the coming years. 

Competition: A White House priority

The Biden administration signaled its focus on competition in July 2021 by signing an executive order that affirmed its policy “to enforce the antitrust laws to combat the excessive concentration of industry, the abuses of market power, and the harmful effects of monopoly and monopsony.”

In January 2022, U.S. antitrust regulators sued to block Lockheed Martin’s $4.4 billion purchase of Aerojet Rocketdyne. Aerojet Rocketdyne produces the propulsion systems needed for hypersonic weapons, a primary area of research and development investment for the DOD. Lockheed Martin walked away from the deal in February, marking a win for the Federal Trade Commission.

Similar concerns hit the windshield for government services firms in June when the Justice Department sued to block Booz Allen Hamilton’s acquisition of EverWatch, a deal that was announced in March and expected to close in June. The DOJ cited concerns around the deal limiting competition for certain federal intelligence contracts.

In a consolidating industry with a robust mergers and acquisitions market, contractors must consider antitrust concerns when assessing their acquisition pipeline, especially in light of actions the administration is taking to promote competition. Private equity investors must do the same in their exit scenario planning. The federal government will allow segments of the ecosystem focused on defense and national security to consolidate only so much.

Looking ahead

Strategy involves maximizing what can be controlled and scenario planning for what cannot. Government contractors face a variety of exogenous factors outside of their control—geopolitical conflict abroad, unpredictable timelines in Congress and antitrust regulators blocking transactions. Those that are poised and ready to respond when circumstances escalate, de-escalate, progress or halt will reap the reward of their planning and predictions. Discipline, focus and objective reassessment, however, will be required in the waiting.

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