From May to the end of June, many investors appeared to have fallen under a spell, writes Andrew Harmstone, portfolio manager for the global multi-asset team at Morgan Stanley Investment Management.
Reminiscent of Titania, who - in Shakespeare's A Midsummer Night's Dream - fell in love with Bottom, a comic character with the head of an ass, investors fell in love with the bond market. This caused yields to fall and triggered a sell-off in the equity market.
Near the end of June, the spell broke, sending yields sharply higher as investors realised that the bond market was not quite as attractive as they had thought.
Considering that we are in a low-volatility environment, underpinned by a broad-based global recovery, we view investors' brief love affair with bonds as a temporary delirium, triggered by a softening in inflation and concerns that it would not pick up again.
However in June, the European Central Bank's stated support for higher interest rates suggested confidence in the health of the eurozone economy, easing investors' concerns over inflation. This led them to sell bonds.
The Fed also appears to be undeterred by weaker than expected US inflation, reflected in its continued resolve to increase rates, given evidence of strong economic foundations.
One of the illusions in June seems to have been investors' expectation that wage rates would go up immediately as economic recovery took hold.
Reinforced by low oil prices, the lack of wage growth has helped keep inflation down, and many investors have been under the misapprehension that this is a sign of economic malaise. This, in turn, made bonds appear attractive.
But it was an illusion. Business fixed investment has been low for many years, indicating that companies have been holding back on upgrading their old machinery and systems, underscored by the average age of capital stock: in the US, it is currently 21.75 years, whereas in the mid-1980s it was below 19 years.
Although it may initially make sense to hire more workers when demand ticks up, eventually increased hiring puts upward pressure on wages.
Management can only afford to pay these higher wages after employee productivity increases, which incentivises investment in more efficient equipment.
In other words, capital investment improves productivity, which drives wage growth.
Only once investments in fixed assets are fully operational, will we see productivity rise and, following that, wages. How long does it take for this initial investment to filter through to wages?
The evidence points to about five quarters. The correlation between investment and wage growth is 24% with no time lag, whereas with a five-quarter lag, it strengthens to about 53%.