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For investors in the index funds focusing on the UK such as iShares UK fund (NYSEARCA:EWU), there is no more pressing question than why the British economy continues to underperform the US. This same issue is hurting investors in many popular ADRs and UK-focused stocks like Vodafone (NASDAQ:VOD), British American Tobacco (NYSEMKT:BTI), WPP (NASDAQ:WPPGY), BP (NYSE:BP), BHP (NYSE:BHP), Astrazeneca (NYSE:AZN), Pearson (NYSE:PSO), HSBC (HBC), News Corp (NASDAQ:NWSA), Unilever (NYSE:UL) and ARM Holdings (NASDAQ:ARMH). Collectively, stocks like these with heavy exposure to the United Kingdom have underperformed peer US firms by 9% over the last 2 years.

Even for those stocks with a large portion of sales coming from international sources, the economy in the UK continues to damper enthusiasm among many investors. Given the similarity between the US and the UK in terms of the structure of the economy and the past performance of both nations, the obvious question is, 'How is the UK doing compared with the US?'

Despite a vast budget deficit of nearly 7% of GDP, a nearly 30% fall in the pound sterling, very low nominal and real interest rates, and nearly $600 billion in quantitative easing, the UK is barely staying out of recession. The government there is now forecasting GDP growth of 0.6% this year, and in the near term, the UK economy looks like it could be headed back into a third shallow recession based on the 1.2% decline in industrial production last quarter. Unfortunately for the UK, with inflation running above the Bank of England's target of 2%, there is little more policy makers can do to stimulate the economy without stoking further inflation. (Data source here) While all economic data is subject to some degree of uncertainty, by almost all measures, the US is doing considerably better than the UK.

What is causing these issues? Why is the UK doing so badly and what does this mean for British stocks going forward? There seem to be three major factors weighing on the British currently. The first two are widely recognized, but the third does not seem to be discussed much.

First and foremost, Great Britain is closely connected with the fortunes of Europe, and with Europe doing so badly, Great Britain is in trouble as well. This is partially offset by the weakening pound sterling (which is itself primarily a result of concerns over future weakness in the nation's economy), but the effect of a weak Europe is still significant for the island. While the US is historically the biggest export market for British goods, the next seven largest markets historically are all various European countries. With the broader European economy looking anemic at best, it should be no great surprise that British manufacturers are exporting less than they did in the past.

The basic supply and demand graph below illustrates this point. While it is unquestionably clear that a declining pound sterling has helped, the data indicate that the demand crunch for UK exports has been much larger than the benefit from a lower currency value. The result has been a fall in net exports which plays into GDP through the standard equation (GDP = Consumption + Investment + Gov't Spending + Exports - Imports).

Secondly, the austerity program the British have enacted is definitely hamstringing the economy. To the extent that austerity programs have any beneficial effects for an economy, the benefit will primarily be felt through two mechanisms: less crowding out of private investment by government investment and greater confidence in the fiscal future of the nation leading to lower cost of capital and higher levels of business activity. Unfortunately neither of these effects is an issue for the UK currently. Private investment is currently very limited due to concerns about the economy, and as a result, there is very little crowding out occurring as evidenced by the extremely low rates the UK faces. Further, the concerns over the future of the economy seem to be causing significantly more loss of confidence than the austerity is providing.

Third, the UK as a whole and London in particular, may have a structural employment issue. Historically the London was a major financial center, and while it is still one of the most important financial capitals in the world, finance as a contributor to global GDP has fallen markedly. Nowhere is this more true than in Europe, and as a result, many British banks have laid off large numbers of employees. In essence, Britain shares something in common with Cyprus here; both economies depended heavily on finance as a source of employment and national GDP. Now fortunately for the British, their economy was nowhere near as dependent on finance as the Cypriot economy was, but nevertheless with the financial sector having shrunk rapidly in the last few years, it is inevitable that the Brits would be left with too many bankers and not enough engineers, doctors, and other skill occupations.

So what does this mean for British stocks?

Mainly it is likely to mean that the national overhang associated with these companies is likely to continue until one or more of the above issues is resolved (and all of them look likely to take a while to work through). The companies that are most exposed to the weakness in the British economy are those that do much of their business domestically. Vodafone is a notable example that has been a significant underperformer of late. Its saving grace in the last few weeks has only come as a result of the significant value of its stake in Verizon Wireless. Similarly, Pearson and News Corp may struggle going forward. In contrast, Unilever, which does 80% of its sales internationally, and ARMH, which is well positioned in an expanding space, look likely to be able to shrug off much of the UK associated weakness.

Source: Why British Stocks And The U.K. Economy Are In Trouble