In a video message to supporters, Ms Phillips said the successor to Jeremy Corbyn needed to be able to “unite all parts of our movement”, MPs, members and the trade unions.
But she admitted: “I have to be honest that at this time, that person isn’t me.
“In order to win the country, we are going to have to find a candidate in this race who can do that and take that message out to the country of hope and change for things to be better.
Emily Thornberry was the first rival to react, scotching any suggestions that she too would soon throw in the towel.
“I’m very sorry to see @jessphillips drop out of the contest – we need to broaden our debate, not narrow it, and force the two favourites to prove they’re up to the fight by pitting them against some real strength,” she tweeted.
“Jess is a sad loss in that effort, but we will keep going.”
Lisa Nandy, the third candidate struggling to challenge the favourites Keir Starmer and Rebecca Long-Bailey, said: “I’m sorry to see Jess drop out. She has made waves, shown great friendship and I’ll miss her in this contest.”
The battle to replace Jeremy Corbyn as Labour leader
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Ms Phillips, a Birmingham MP who was backed by many centrist Labour MPs, has quit after failing to win the endorsement of Usdaw, the shopworkers’ union.
It was the only one of the “big five” unions even considering supporting her, to help her reach the threshold of 5 per cent of the affiliated membership.
Without that support, she was faced with the Herculean task of winning the backing of 33 local constituency parties in order to stay in the race – but was yet to be endorsed by any.
Although Ms Phillips stopped short of endorsing Sir Keir, as some expected, her withdrawal is a boost to the frontrunner’s campaign.
Early polling suggested most of her supporters picked the shadow Brexit secretary as their second choice – and one pollster predicted he could now win outright in the first round of voting.
Labour has yet to reveal how many people joined the party in the two-week window allowed in order to vote in the race. The result will be declared on 4 April.
In an article for The Independent, she attacked Labour figures who have sought to “appease” right-wing critics of immigration such as Nigel Farage and Michael Gove.
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