In the first minute of trading, the FTSE 100 share index fell 1.3 percent before recovering somewhat by midday to trade 0.7 percent lower at 5,224. That follows a drop of 1.5 percent on Thursday, when world markets were gripped by a fear that Greece's debt crisis could derail the global recovery.
The British pound traded as low as $1.4449 by late morning, down sharply from $1.51 less than 24 hours earlier.
U.K. Election Deadlock Continues
Beyond the global turmoil created by the debt crisis, the incomplete election returns worried investors - with no party claiming a majority, it was unclear what the next government's approach would be to slashing a ballooning debt while nurturing a so-far feeble recovery from recession.
The potential lack of a strong government "does not bode well for implementing the harsh cuts that need to be implemented to cut the budget deficit," said Marc Ostwald at Monument Securities in London.
The opposition Conservative Party claimed the largest number of seats, though short of a majority. Possible options include a minority government led by the Conservatives, coalitions involving the Conservatives or possibly a multiparty coalition excluding them.
"The worst thing for markets would be a coalition government failing in a few months and a new election being called," said James Knightley at ING Bank. "This would intensify the pressure on ratings agencies to downgrade the U.K.'s sovereign rating from AAA and make fiscal consolidation even more difficult."
Amid such cries of alarm, credit ratings agency Moody's Investors Service said Britain's AAA rating was not directly threatened by the election outcome.
"Moody's stance assumes that the incoming economic team can muster convincing parliamentary support for a fiscal adjustment that is no looser nor slower than was outlined by all three political parties during their respective pre-election campaigns," said Arnaud Mares, senior vice president in the agency's Sovereign Risk Group.
Simon Hayes at Barclays Capital said one possible outcome, a minority government, would leave the markets uncertain about economic policy because of the greater difficulty of passing legislation.
He added that if a Conservative or Conservative-led administration were to emerge, bond prices, equity prices and the pound could all rise.
A sharp and sustained slump in the pound was also seen as a threat to inflation - because imports become more expensive - and therefore the country's long period of record low interest rates.
The Bank of England's base rate has held at 0.5 percent since March 2009.
The Bank's rate-setting Monetary Policy Committee began its monthly meeting on Friday, and will announce its latest decision on Monday. Inflation is currently at 3.4 percent, well above the Bank's target of 2 percent.
"The pound has fallen by five cents in the past three days," said Douglas McWilliams, chief executive of the Center for Economics and Business Research. "If the slide continues, the MPC will almost certainly have to raise base rates to hit their inflation target."