The news that Bush is proposing a 7% increase in technology spending came a day before Cisco Systems, the tech firm perhaps most closely attuned to the macroeconomic climate, disappointed analysts with its second-quarter sales.

Announcing earnings for the three months to January 29, Cisco CEO John Chambers broke from his usual script to say that money redirected to Iraq had caused a 40% sequential decline in federal bookings in the period.

The federal business is a little challenging, as many of our peers are also experiencing, he said. Orders were flat year-on-year and down sequentially approximately 40% due to normal federal seasonality and a realignment of spend priorities.

The realignment is occurring as funds are being refocused, due to geopolitical and Middle-East issues, Chambers, whose quarterly remarks are closely scrutinized by analysts, said during a conference call Tuesday.

Tech companies that have large federal businesses – Cisco’s government business is about a fifth of sales – have warned about the potential impact of Iraq ever since the war began. Many have reported sales misses as a result of diverted funds or federal uncertainty.

Veritas Software Inc reported US licenses down 13% year-on-year in late January, due to weakness in telecommunications and government, and in an interview with ComputerWire, CEO Gary Bloom fingered Iraq.

Certainly there’s an effect from the diversion of funds to the war, Bloom said at the time. Most of the internal [federal] departments are saying that they don’t know what their budgets are going to look like.

Security, the only billion-dollar business of Cisco’s six advanced technology growth markets, has taken a hit also – F5 Networks Inc and other VPN firms blamed federal weakness for misses in the fourth quarter and earlier last year.

Bush’s proposed budget contains provisions to increase federal tech spending from $60.9bn to $65.2bn in fiscal 2006. He said: The 2006 Budget supports the development of technology and innovation throughout our economy.

Spending on security technology would increase about the same amount, a little over 7% to $1.68bn. The overall budget proposal still has to make its way through Congress, where it is expected to meet challenges from the opposition Democrats.

As far as Cisco is concerned, the firm did not break out precisely how much the slower than expected government sales hit its revenue, which came in at $6.06bn, a little less than the analyst consensus estimate of $6.13bn.

Revenue was up a very respectable 12% on to the year-ago period. The company reported profit of $1.48bn for its second fiscal quarter, $0.22 per share, in line with analyst estimates, compared with a profit of $1.32bn a year earlier.

Chambers said he believed that Cisco is gaining market share on its competitors in the six non-core growth areas it has identified – VoIP, storage, security, home networking, optical networking and wireless – when comparing calendar quarters.

From a US perspective it was the first Q2 we’ve seen in a number of years with very solid year over year growth rates across all nine enterprise an commercial geographic areas, he said. Q2 is usually seasonally slow for Cisco.

The company’s mix of revenue switched a bit from earlier quarters. Routers were up to 22% of revenue, switches were down to 40%, the six advanced product lines were up 3% to 19%, and services were 15%.

Home networking and VoIP are fighting it out to become the second of Cisco’s growth markets to hit a $1bn annual run rate. Both segments saw Q2 revenue of about $220m, growing at 40%, he said. Storage grew fastest, at 70% year-on-year.