Jen DiMascio Washington

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.