By David Coombs

The Conservative leadership election is down to the last two, one of whom will become our next prime minister. Economically, the two different candidates offer two very different policies.

On the one hand we could have tax rises, more modest interest rate rises and currency weakness. On the other are tax cuts, higher interest rate rises and potentially a more stable currency in the short term. Both will impact people’s finances and both will require a slight rethink in how to invest going forward.

First, let’s think about what it could mean if former chancellor Rishi Sunak wins the race.

We will find out soon enough whether Mr Sunak was carrying out Prime Minister Boris Johnson’s wishes when he previously set out the Government’s fiscal policy or whether he stands behind what he has done.

Let’s assume that what we have seen so far was the result of his own policies, which would result in more of the same. Essentially, it would mean the tax rises he has initiated will continue as is and that would make raising interest rates a bit more difficult for the Bank of England.

So far, the Bank has been reluctant to increase interest rates as aggressively as the Federal Reserve in the US. Why? Because taxes are also rising, and any economist will tell you that raising taxes and interest rates at the same time

is a sure sign you will end up in a recession.

If the Government has a fiscal tightening programme, it needs to be careful not to tip the economy into a recession. This is despite bond markets indicating we are heading into a recession, with yields coming off their previous highs.

What does this mean for investments?

Continued tax rises and lower interest rates could lead to further sterling weakness. This, in turn, will put significant margin pressure on UK domestic businesses. Such a scenario could result in the FTSE 100 outperforming the FTSE 250, driven by stronger earnings for firms with overseas earnings, like Royal Dutch Shell, BP or Vodafone.

UK businesses are already experiencing margin pressure because of rising prices. One example of this is in the car insurance sector. We could also see some dividend cuts in these more domestically exposed sectors.

But what if the winner is Foreign Secretary Liz Truss? She has indicated she will cut taxes and increase spending to revitalise the UK economy. This would include reversing this year’s National Insurance increase and cancelling the rise in corporation taxes. The first question is how will she achieve this?

She has suggested the Government could package up Covid-19 debt and sell it off, just as it did back in the Second World War with war loans. It’s difficult to predict whether this will work or not. For it to work, she would first need to convince the bond markets to buy the loans.

What’s more important though is the impact tax cuts will have on the wider economy.

Cutting taxes could potentially reduce the risk of recession. That would give the Bank of England a bit more flexibility in raising rates. And this, in turn, could mean sterling recovers.

In this scenario, consumer discretionary names may perform better, not least because support for lower to middle earners through the cost-of-living crisis could eventually funnel more everyday spend into names such as Lidl, Primark-owner ABF and B&M. We don’t currently hold any of these names in the funds, but could domestic firms offer more value in this environment?

One issue with Ms Truss’ plans, as highlighted by numerous economists, as well as Mr Sunak, is that they could be inflationary.

The reality, of course, is inflation is a global problem, caused partly by the war in Ukraine and its impact on commodities, partly by economies still recovering from the massive shock of Covid-19 and partly by China still having a large part of its economy shut down due to the pandemic.

There are a lot of forces outside of the control of politicians and central banks that are impacting inflation.

It’s too early to make drastic changes to portfolios at this stage in the race. Ultimately,

the question will boil down to how overseas investors regard the new administration.

One thing is clear – we won’t know who our PM is going to be until September 5. That could mean further volatility for sterling, so having an active currency strategy might be sensible.

In my view, the best firms to invest in are those that are less reliant on the vagaries of government or central bank policies. Instead, they tend to dominate their markets due to better quality products, or services and offer customers the best value for money. They are the true defensives.

David Coombs is head of multi-asset investments at Rathbones.