LONDON (Reuters) - Markets opened Monday without clarity on who will govern Britain with a workable coalition rather than unstable minority rule needed to pacify investors jittery over the euro zone's Greek debt crisis.
Sterling, gilts and stocks all sold off on Friday after the Conservatives failed to win an outright majority in Thursday's elections, leaving Labour Prime Minister Gordon Brown defeated but still in power and the Liberal Democrats as kingmakers.
The Conservatives and Liberal Democrats held talks over the weekend to try to put together a government, but while delegates said progress had been made they failed to reach an outright agreement but will meet again on Monday.
Both Conservative leader David Cameron and LibDem leader Nick Clegg face an uphill task selling any deal to their respective parties. Investors wanting swift action on Britain's record deficit are unlikely to be particularly patient.
"I think the markets will give them a nudge on Monday and then a much larger nudge on Tuesday," said David Lea, Western Europe analyst at consultancy Control Risks. "It really has to be sorted out by Monday night."
Asian markets will be the first to digest the weekend news, while London markets could be buffeted by new statements and appearances by party officials on early morning television and radio.
"Market reaction on Monday ... will depend in significant part on what the parties are saying publicly," said Alistair Newton, political analyst and managing director at Nomura.
If both parties were sending positive messages suggesting they had a basic agreement on the principles of a coalition but needed time to cement details, markets could react positively.
But negativity, conflict and intransigence could alarm markets wanting a strong government to begin tackling Britain's record deficit. Some analysts took heart from Conservative and LibDem statements saying there was common ground on the economy and deficit reduction.
"I don't think the market was expecting a deal by (Monday) opening," said Eurasia Group analyst Wolfango Piccoli. "The politicians are being very positive and responsible. By talking about the deficit, they are sending the right signal."
Denied a decisive election outcome, most analysts say the most stable outcome would be a Lib-Con coalition rather than a looser arrangement with the LibDems providing parliamentary support from outside the government.
Nevertheless, some analysts said the most likely outcome was the latter, with the Lib Dems agreeing not to vote down key policies, particularly the budget, but with differences over electoral reform -- a key LibDem goal largely opposed by the Conservatives -- preventing a coalition.
Such negotiations are common in European politics but Britain has not seen a hung parliament since 1974.
Analysts say the average length of time to form a European coalition is 40 days, but with markets already nervous over sovereign debt worries given the crisis in Greece and other southern euro economies few believe Britain has such a luxury.
The new government is due to set out its legislative programme in the Queen's Speech to parliament on May 25. Investors and credit ratings agencies will watch closely.
"The UK's relatively high debt ratios and large deficits could result in the UK becoming a bad-weather version of Club Med debt markets," said ING in a research note on Friday, using a standard shorthand for the troubled economies of Italy, Greece, Portugal and Spain and underlining that Britain might be next in the firing line.
Conservative leader David Cameron could try to push ahead as a minority government with the support of a handful of Ulster Unionists, and the LibDems agreeing to protect him against a no-confidence vote to allow a budget through.
But markets fear this option would prove inherently unstable and might simply be too weak to tackle public spending, potentially endangering Britain's AAA credit rating.
"I think investors would react negatively to a minority government given the risk that a no-confidence vote could emerge in parliament before year-end," said Simon Derrick, head of currency strategy at Bank of New York Mellon.
Some analysts, however, argue no party would risk forcing a no-confidence vote for fear of being punished by the electorate for a market crash.
The sheer uncertainty makes markets favour a broader coalition.
If the Lib Dems and Conservatives proved unable to form a coalition, one could potentially be put together by the LibDems, Labour and multiple other smaller parties including Scottish and Welsh nationalists.
Brown and Clegg met on Sunday, a potential sign that the Lib Dems were keeping their options open.
But any Lib-Lab-Others coalition would barely have a majority and investors would likely be lukewarm at best.