LONDON, Aug 8 (Reuters) - The race to be the next leader of Britain's ruling-Conservative Party and the country's prime minister is into its final leg, with the September outcome likely to shape the fortunes of sterling, gilts and UK stocks in coming months.
The contest between foreign minister Liz Truss and former finance minister Rishi Sunak to succeed Boris Johnson has centred on clear policy dividing lines.
Sunak has vowed to control inflation and accused his rival of pushing for unfunded tax cuts that only fuel price pressures. Truss has said her priority is to kickstart growth and the tax cuts she plans to do will not be inflationary.
Here's a look at some of the assets that could emerge as likely winners and losers.
The pound could be a short-term winner. If either candidate embarks on tax cuts, the economy could get a short-term boost and the Bank of England (BoE) may be inclined to keep hiking rates to ward off further price pressures.
Sterling has slid 10% against the dollar this year. That's partly because the BoE has hiked at a slower pace than the Federal Reserve, even with Thursday's big rate hike.
A BoE more determined to raise rates because of looser fiscal policy should help sterling.
But its longer-term fortunes will be tied to the economy. The BoE has just warned of a recession with a peak-to-trough fall in output of 2.1%.
If lower taxes fail to stimulate growth as Truss predicts, and worsens government finances, sterling could struggle. Her proposal to review BoE independence could also weigh. Any greater government role in monetary policy would hurt confidence in Britain's economy.
British government bonds, or gilts, are in the losers' camp for now. Investors sense the outcome, especially if Truss wins, will lead to more fiscal stimulus, higher inflation and rates.
Citi forecasts a further net fiscal boost of 40 billion pounds ($49 billion) over the coming 12 months, adding 0.8 percentage points (pps) to economic growth by end-2023 and 0.4 pps to underlying inflation by 2024.
ING economist James Smith said that 30 billion pounds of tax cuts, as proposed by Truss, would likely require an extra 25-50 bps of BoE tightening.
Higher rates for longer could further lift 10-year gilt yields, already up almost 100 bps this year to 1.92% .
LEVELLING UP THE FTSE
Higher bond yields could hurt equities, especially growth stocks, said Investec chief economist Philip Shaw, noting the difficulty in making sector-specific conclusions just yet.
"For example, hypothetically are we looking at more levelling up? If we are, perhaps infrastructure stocks could get a boost, but we were hearing Truss was trying to cut salaries outside London, which doesn't exactly signal a commitment to levelling up," he said.
Truss has backtracked on a pledge to introduce regional pay boards. Johnson's "levelling up" agenda to reduce regional inequalities helped his 2019 election win.
Truss' promise to halt an increase in corporation tax also means stock markets might welcome a Truss victory over a Sunak one, although the outlook for the economy will likely remain the bigger driver.
The FTSE 100 is up just 0.9% in 2022, but has outperformed European shares which are down 10%.
DEFENCE, RENEWABLES, INSURERS
Some sectors were in focus as the contest plays out.
AJ Bell's head of investment analysis Laith Khalaf said Truss' plans to raise defence spending to 3% of economic growth could give defence stocks "a little pump".
Focus on security spending following Russia's invasion of Ukraine has helped lift the FTSE 350 aerospace and defence sub-index almost 15% this year, versus a broader 1.8% drop for the FTSE 350.
Khalaf added that a Sunak victory could boost the renewable sector given Sunak's "full-throated commitment to net zero".
Truss has said she will review how Britain will reach its 2050 net zero target to see how it can be done in a more "market-friendly" way.
Finally, insurers such as Aviva and Legal & General could be among the winners.
Truss has said she wants to reform Solvency II rules, a legacy of EU membership, which govern the amount of capital insurers need to hold against their investments.
Insurers are lobbying to hold less capital against riskier assets such as infrastructure, a change which they say will help them fund economic growth.
(Reporting by Tommy Reggiori Wilkes, Dhara Ranasinghe, Samuel Indyk and Lucy Raitano; additional reporting by David Milliken, Bill Schomberg and Carolyn Cohn; Editing by Dhara Ranasinghe and David Evans)