On the face of it, the financial markets of developing economies have performed remarkably well in the past several months. Since March 23, the MSCI Emerging Market Index – the main gauge of stocks in developing nations – has surged 31 per cent, leaving it 3.7 per cent below its peak on January 12, just before the Covid-19 pandemic sent global markets into a tailspin. Sentiment has also improved significantly in bond markets. The average yield on local currency emerging market government bonds has fallen to a record low of 4.3 per cent, down from 6 per cent at the end of March, according to data from JPMorgan. US dollar-denominated corporate debt has also enjoyed a strong rally, with spreads falling sharply since late March. However, a cursory glance at data on fund flows – a more accurate gauge of sentiment – shows the extent to which the fallout from the pandemic has shaken confidence in developing economies. Data from JPMorgan reveals emerging market equity and bond funds have suffered outflows this year amounting to US$65 billion, putting the funds on course for their second-worst year since data on portfolio flows became available in 2004. Many of the most actively traded emerging market currencies have suffered dramatic declines. The Brazilian real is down a whopping 31 per cent against the US dollar this year, while the South African rand and the Turkish lira have dropped 23 and 18 per cent respectively. This may seem odd given all the talk about the sharp fall in the US dollar . The dollar index – a gauge of its performance against a basket of other major currencies – has lost 8 per cent since May 14. However, much of the dollar’s decline has been against the euro, which accounts for nearly 60 per cent of the index. As Robin Brooks, the chief economist of the Institute of International Finance, has pointed out in numerous tweets during the past month, the US dollar remains significantly overvalued versus emerging market currencies. Since late March, the Bloomberg JPMorgan Asia Dollar Index – a gauge of the performance of Asia’s most actively traded emerging market currencies versus the US dollar – has risen nearly 4 per cent. Brooks notes that emerging market currencies remain under pressure partly because of China’s reluctance to launch a large-scale stimulus programme akin to the one deployed during the 2008 financial crisis. The previous measures triggered a boom in commodity prices, which allowed emerging market currencies to strengthen against the US dollar. Another reason currencies in developing economies are under strain is because the pandemic has forced central banks to cut interest rates aggressively and, in some cases, embark on quantitative easing. This has reduced the interest rate gap between developing and developed economies, diminishing the appeal of holding money in emerging market currencies. More worryingly, the whiff of a fiscal crisis hangs over several major developing economies. According to a July 9 report by JPMorgan, huge increases in public spending in response to the pandemic have caused fiscal deficits in emerging markets excluding China to nearly triple, from an average of 3.1 per cent of GDP last year to almost 9 per cent this year. In Brazil, India and South Africa, budget deficits will exceed 13 per cent of GDP. Public must share blame for looming global debt crisis So far, governments have been able to fund themselves thanks to the virus-induced surge in liquidity in the financial system. At some point, though, austerity programmes will need to be enacted, which could undermine the recovery. The challenge is particularly acute given that many emerging markets, especially in Latin America, are struggling to contain the spread of Covid-19. The virus is more difficult to suppress there because of much larger informal sectors and the limited health and fiscal capacities of governments. Brazil and India now have the second- and third-highest number of confirmed cases after the United States . The costs of imposing lockdowns and social distancing measures in developing economies are far greater. As the International Monetary Fund warned in June, “for the first time, all [emerging market] regions are projected to experience negative growth in 2020.” As if this was not bad enough, the dramatic escalation in tensions between Washington and Beijing , coupled with the most unpredictable US presidential election in recent memory, create a highly volatile backdrop for asset prices. Sentiment is particularly vulnerable because, in contrast to retail investors, fund managers have been pouring money into emerging markets. According to JPMorgan, there is “not much social distancing in [emerging market] allocations”, with positioning in government bonds at its highest level since 2004. Make no mistake, emerging markets are undergoing their toughest stress test. Even China’s impressive rebound is being called into question because of the severity of the global recession and the resurgence of the coronavirus. Emerging markets have proved resilient in the past. Even so, overcoming the fallout from Covid-19 would be a remarkable feat. Nicholas Spiro is a partner at Lauressa Advisory