By Jim Wolf and David Alexander
WASHINGTON (Reuters) - Pentagon officials and weapons makers on Wednesday expressed relief after Congress approved a two-month delay in huge budget cuts, but warned that a longer-term fiscal solution is urgently needed to lift the uncertainty hanging over the sector.
"Congress has prevented the worst possible outcome by delaying sequestration for two months. Unfortunately, the cloud of sequestration remains," Defense Secretary Leon Panetta said in a statement. "Congress cannot continue to just kick the can down the road."
Votes by Congress on New Year's Day delayed automatic budget cuts known as "sequestration" until March 27, when lawmakers must vote to increase the U.S. debt ceiling.
The 157-page deal reached on Tuesday to avert the "fiscal cliff" delayed $109 billion in U.S. spending cuts - including $54.7 billion due to come out of military spending, but left many larger issues unresolved.
Defense shares were lifted by a rally in the overall market as investors breathed a sigh of relief about the last-minute deal, but some companies' shares lagged the broad market due to continued uncertainty about future military spending.
"Merely delaying sequestration by a couple of months will do little to resolve the uncertainty and chaos surrounding the defense budget," said Todd Harrison, an analyst at the private Center for Strategic and Budgetary Assessments.
Lockheed Martin Corp
Until then, "there will be an overhang on our industry that stifles investment in plant, equipment, people, and future research and development essential to the future health of our industry," said Jennifer Whitlow, spokeswoman for the maker of F-35 fighter jets and Aegis missile defense systems.
Lockheed's shares closed 1.1 percent higher on the New York Stock Exchange, trailing 2.5 percent gains for the overall Arca Defense Index <.DFII> and Standard & Poor's 500 Index <.SPX>.
The biggest defense industry trade group, the Aerospace Industries Association, urged lawmakers to work toward a long-term solution.
"If sequestration is not solved in the next 57 days, it would be an abdication of responsibility by the leaders of this country, one that will only heighten Americans' cynicism and cement the public image of a gridlocked Washington that simply doesn't work," said the group's president, Marion Blakey.
Lockheed and other big arms manufacturers including Boeing Co
Northrop Grumman shares closed 0.9 percent higher on Wednesday while Boeing advanced 2.3 percent. General Dynamics Corp
The U.S. unit of Britain's BAE Systems
The cuts are setting up to be even more painful if lawmakers don't agree on an alternative by March 27, since they would have to be squeezed into a shorter period.
President Barack Obama has excluded uniformed military personnel from being hit by the spending cuts, but some of the department's 800,000 civilians could face up to four weeks of furloughs, or unpaid leave.
If the Pentagon must implement cuts after the March deadline, hundreds of thousands of employees may be forced to take up to a month of leave within just four months, which could create significant disruption of Defense Department operations.
Pentagon spokesman George Little could not specify how many civilians might be furloughed if the cuts were implemented, but he declined to rule out the possibility that virtually all 800,000 might have to take at least some unpaid leave.
"This is not an abstract concept. This is something that will have an impact on real people, doing real work on real missions for this department," Little said.
Loren Thompson, a Virginia-based defense consultant, said the news was not all bad.
He said the last-minute agreement by lawmakers signaled that sequestration cuts were unlikely to ever be implemented as currently planned, although some additional cuts were likely.
"When the chips are down, the two parties can find common ground and that means sequestration is not going to happen the way it is currently mandated," Thompson said. "This is not just a reprieve for the defense industry, it's a signal that the worst aspects of sequestration are never going to occur."
Byron Callan, analyst with Capital Alpha Partners, said an eventual compromise was likely to include some further cuts to defense spending, in addition to $487 billion in cuts already due to be implemented over the next decade.
"Defense spending absolutely will be part of the next debt ceiling/sequestration cliff debates," Callan wrote in a note to investors.
(Additional reporting by Andrea Shalal-Esa; editing by Ros Krasny, Phil Berlowitz and David Gregorio)