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Economy grew at 2.5 percent in 1st quarter, amping fears of a stalled recovery

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A steep slowdown in defense spending tied to the end of the wars in Iraq and Afghanistan is undercutting the country’s economic recovery, new government data released Friday revealed.

The report showed gross domestic product grew at an annual rate of 2.5 percent during the first three months of the year — significantly slower than most economists had expected. The culprit? A surprising 11.5 percent annualized drop-off in military spending.

The decline comes on the heels of an even bigger plunge in defense spending at the end of last year that brought economic growth to a standstill. Taken together, the two quarters represent the steepest declines in military outlays since the Korean War, according to JPMorgan Chase economist Michael Feroli.

The GDP report amounts to a caution about the looming consequences of federal spending cuts known as the sequester. The cuts officially began in March but could take months — or even years — to fully digest. The Congressional Budget Office estimates that the sequester will shave nearly half a percentage point from economic growth this year, delaying projections for economic liftoff to 2014.

“The longer-running story has not changed, as the economy remains mired in the pattern of slow and uneven growth seen since the end of the Great Recession,” said Richard Moody, chief economist at Regions Bank.

Consider just the past year of the recovery. Last spring, the economy was treading water before the pace of growth picked up to more than 3 percent at an annual rate over the summer. But hopes for a sustainable recovery dissipated by the end of the year when economic growth stalled.

The bounce-back this year has been weaker than expected by many analysts, who have already begun warning that any momentum that had built up has likely already cooled. Economists forecast that the growth rate during the second quarter will be an anemic 1 to 2 percent.

Even the good news in the GDP report came tempered with caveats: The biggest single driver of growth during the first quarter was a surge in business inventories, contributing about one percentage point of growth. But economist Ben Herzon of Macroeconomic Advisers noted that most of that stockpiling was done in January.

Consumer spending was also strong during the first quarter, rising 3.2 percent. Analysts have attributed the jump to the large number of bonuses paid late last year to avoid the bite of higher taxes this year. Consumers spent that extra money in the first quarter, but that boost will disappear over the year. In fact, some data suggest households are already beginning to draw back as higher payroll taxes squeeze paychecks.

Meanwhile, defense spending has been a drag on growth for the past two years. A decade after the terrorist attacks of Sept. 11, 2011, America officially ended the war in Iraq and killed al-Qaeda leader Osama bin Laden. President Obama also announced in 2011 a timeline for withdrawing from Afghanistan.

That shift in foreign policy is still trickling through the real economy. Compensation for military and civilian employees working in defense have fallen every quarter since 2012. Major contractors such as Lockheed Martin have laid off or bought out hundreds of employees, including top executives, and consolidated facilities in recent years.

Defense procurement reached its height in 2008 at nearly $400 billion for the year, and it has fallen steadily since. Last year, contract awards dropped 15 percent below the peak, after adjusting for inflation.

But many of those contracts are for complex weapons and machinery that can take years to build. The GDP report does not count them as government purchases until they are actually delivered. In other words, much of the slowdown in contract awards is only now showing up as a decline in government spending.

That also means the Pentagon’s $500 billion in budget cuts required by the sequester could hold back GDP growth for years to come.

“If you’re looking at earnings of defense companies, you’re not going to see a hit on that for a while as a result of sequestration,” said Todd Harrison, a senior fellow in defense budget studies at the Center for Strategic and Budgetary Assessments.

Fairfax-based ManTech International is a prime example of the effect of wartime spending reductions. The contractor depended heavily on battlefield work and has seen significant financial declines. Its 2012 profit of $95 million was down nearly 30 percent from 2011.

Now the company is also facing cuts from sequestration. In an earnings call in February, as the deadline for implementation loomed, top executives highlighted the uncertainty of its impact on their bottom line.

“Nobody has a crystal ball on what’s going to happen with sequestration,” Chief Financial Officer Kevin M. Phillips said. “We’re taking a conservative view based on the uncertainty. . . . Does it cover the worst-case scenario? There’s no ability to tell right now.”

Jim Tankersley contributed to this report.

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