By Amanda Cooper and Jesús Aguado

LONDON/MADRID Spanish blue-chip shares dropped Monday after a snap general election at the weekend yielded no clear winner, with investors punishing banks and utilities in particular.

Spain faced political gridlock on Monday after the right-wing parties failed to clinch a decisive victory and no clear winner emerged in Sunday's national election, leaving Basque and Catalan small regional parties as potential kingmakers.

This outcome could ultimately lead to the extension of a windfall levy on the financial and energy sector beyond the current two-year period.

"The generalised falls are due to the fact that the market is expecting either a weak government or an election ahead. Now a period of uncertainty is opening up, which is the worst possible scenario for the markets," said Natalia Aguirre, head of analysis at Renta 4.

Madrid's IBEX 35 equity benchmark index fell by as much as 1.8% in early trading, underperforming the broader STOXX 600, which fell 0.3%, while the euro held steady on the day at $1.1126.

The centre-right People's Party (PP) and the far-right Vox won a combined 169 seats in parliament, while the ruling Socialists (PSOE) and far-left Sumar won 153, well short of the 176 seats needed for a majority.

"It's a domestic situation we're looking at," City Index strategist Fiona Cincotta said.

"I don’t think it’s necessarily part of a darker outlook for Spain in the longer term, but just think at the moment, we're seeing that uncertainty and markets hate uncertainty," she said.

Shares in major lenders Santander, BBVA, Sabadell and Caixabank were down between 2.0% and 3.5%, ranking them among the biggest decliners across the European stock market.

The nervousness did not just centre around banks. Goldman Sachs said on Monday the outcome of the election may also be a temporary setback for Spanish utilities as the market had recently turned more positive for Endesa and Iberdrola on account of "a potential change in government, and prospects for reduced regulatory intervention".

Endesa dropped 3.7% while Iberdrola fell 0.9%.

Political consultant Eurasia Group said this uncertainty could last months - much as was the case in 2019, when two back-to-back elections were held before a government could be formed.

"For now, repeat elections look like the most likely way out of the deadlock (a 40% probability); if so they would most likely be held in the fourth quarter of this year," Eurasia Group senior analyst for Europe, Federico Santi, said.

Spain's economy has held up relatively well but is slowing from a post-pandemic rebound. The government forecasts 2023 growth of 2.1% versus 5.5% last year.

A slowdown means Spain's high debt of more than 100% of GDP and deficit of 4.8% of GDP are in focus, and drawn out talks to form a government could slow the progress of fiscal reforms and worsen its finances.

The prospect of a hung parliament and another snap election had already been on economists' radars ahead of Sunday's vote.

ING economist Wouter Thierie said before the election that the next government would have to tackle Spain's high debt, as tighter EU fiscal rules come into force in 2024.

"In such a scenario, crucial structural reforms needed for the economy may be delayed, reinforcing existing weaknesses. Persistent uncertainty about future government policies could also undermine investor confidence and hamper investment activities," he said.

The risk premium for Spanish government debt yields compared to benchmark German 10-year bonds held steady at around 102.90 bps.

(Additional reporting by Stefano Rebaudo and Danilo Masoni in Milan; Editing by Dhara Ranasinghe and Angus MacSwan)