The following is an excerpt from our Letter of 30 September.

We've been reading some of Stephen Roach's recent material. It reminds us of the "Roach Motel"? - actually that's a play on words. In the 1970s in the US, there was a television advertisement for Roach Motel insect traps. "Roaches check in but they don't check out". Well, Stephen Roach, chief economist at Morgan Stanley, has been recently revelling on about the likely percentages of an US recession and it seemed a more fitting pun to state - investors check out but they don't check in. Clearly, the discernment of a clear trend is tricky at the moment. Is Stephen right about a recession? It's certainly not a philosophical question - even the Fed is haunted by it's recession analysis. By the way, for an economist, we like the Mr. Roach. He's humble and not an arm jerker. He might be wrong sometimes, but when he is he admits it - we like that. All of us crystal ball lookers usually end up eating broken glass at some point - more often than not. That's what makes the markets so fascinating.

Mr. Roach makes some serious and noteworthy points:

1. The US savings rate is and remains below zero (it's negative); the last time was in 1933 during the Great Depression.

2. 77 million baby boomers in the US are nearing and settling into retirement - many without sufficient savings to sustain a consumptive lifestyle. See Graph - Household credit has boomed over the last 8 years.

3. the US consumer has been extracting spending liquidity from two boom cycles - first it was the tech bubble and then it was / has been the housing boom directly thereafter thus increasing dramatically their debt to real income ratio; Roach's mantra is that there are no more bubbles to "milk" for consumer liquidity as the graph shows US housing both permits and starts crumbling - and - the fact that many mortgages are now being recalculated just as the underlying housing asset is falling in price - that is the the double whammy we previously talked about.

4. With a bust in the construction markets comes a big loss of GDP, nearly 1%; likewise a large portion of employment in the US is based around the property sector.

5. Even the while the Fed claims to be tightening liquidity, the M2 money supply has been expanding at an inclined rate; the overall money supply statistic, M3, was cancelled by the Fed hence either M2 or MZM is all we have to go by.

We have been thinking long and hard about the US recession outlook but how best to present this thinking? Or better, can the past debt growth and money supply growth be maintained such as not to prevent an economic downturn or even a "hard landing"? The easiest thing in the world for the Fed to do is to create money along their defined "core inflation target" of 2%. It's no longer even questioned - that is their stated policy. Likewise, the humble tales of economists who misjudged the US consumer's LOVE for shopping and buying things on credit as we saw in the above household sector debt. Can these trends be sustained? As Mr. Roach has pointed out, the previous bubbles have caused increased world growth on the backs thereof but will it eventually wreak havoc with the US Dollar and the US economy? We took a 40 year snapshot (in 10 year intervals) of those key trends and looked a bit closer.

Some key things come to mind and are worthy of comment:

1. growth in both money supply and debt had been ramping up in fairly even fashion of the 1970 to 1990 period.

2. As pointed out by Roach, around since 10 years things have been slowly "coming off the rails" as both money supply and debt increased their curve angle, what he refers to as "global imbalances" from the US standpoint.

3. If we project out to 2010 those same trajectories, the question of SUSTAINABILITY comes clearly to the front of our thoughts; things are sustainable until suddenly they are not.

4. As can be seen by the thick blue line (at 2010) the percentage growth in debt and money supply becomes near exponential, or absurd.

Nevertheless, this is what the TRUE STORY of the fear regarding the US Dollar is all about. Would the foreign creditors want to see such a development or can the US government get its current account imbalances back in line without causing a world-wide depression? This is why gold bugs start salivating and see the US Dollar losing value and confidence - and they are likely correct in that respect but when?

BUT, let's take a look from the other perspective: Can the world live WITH a more balanced US account?

Although arguing both sides of this pertinent question is relevant to both our investments and economic outlook, it is of major importance to the foreign creditors holding US Dollars and funding the trade account imbalances. There is a very fine line between the extending of the credit envelope and of completely obliterating the TRUST in the US Dollar, because TRUST is the only thing actually holding any fiat currency together - as trust fades interest rates must increase to defend a currency - interestingly however - the US rates are falling which indicates not inflationary tendencies currently but rather a more benign outlook.

We believe there may be two major forces at work here:

1. With global risk comes a flight to perceived safety;

2. US Dollar is the world's reserve currency.

The bottomline is this: The western nations may be facing a recessionary or slowing down but if the economic data starts to turn sour then our conjecture is that Bernanke will need to again raise liquidity (lower rates) because that is in fact one of their core mandates - maintain price stability and growth via managing inflation expectations. In fact, the Fed's core targeted inflation is always around 2%. Our estimation of this from January this year was that by Q4/2006 the FFR (baseline Fed interest rate) would be 5.25 or 5.5% (2 more 25bp hikes). We are sticking by this figure. In fact, we see an easing off of rates by December as this current ferocious market pullback has probably caused sufficent fear in the FOMC committee that the message has been taken and price stability is falling back into line. The lag time for this stablization should last into Q2 of 2007. A final note: We have read economic reports that the targeted inflation rate of 1 to 2% has been missed to the upside and hence all wheels are in motion at the Fed to "bring that sucker" down into "normal channels". The problem with a rule and data based monetary policy is that a) rules don't always work (give the desired results) given the parameters at hand, and b) macro data is always backward looking not forward looking.

The above paragraph was taken from our previous Latest Letter in June. This has thus far been proven correct yet it was a bit too late since the Fed has already started easing their rate regime in September. Here we feel more discussion is needed in order to fill in some of the missing points.

In a world led by US liquidity it would seem an obvious matter-of-fact that should the US liquidity be maintained (steady to falling FFR) then the world's producers may complain of US imbalances yet they will not complain about their current account surpluses as it makes the purchase of resources and commodities (based in US Dollars) easier. This is more or less the current status quo. But as the US imbalances and debt to GDP grow (now approaching 7% in the US - which is more in line with 3rd world countries) the account-surplus-countries must be wondering if the tipping point of an USD implosion is moving closer. Yet the perverse situation is that such an implosion would destroy their USD paper surpluses. That cannot be in their interest. Likewise, in a recessionary environment the so-called savings-poor US consumer might actually start to increase savings which again decreases trade imports and hurts surplus countries grown accustomed to "easy money". It would also imply less world growth as the US is a large global GDP driver. In essence, a non-threatening US 7% GDP imbalance implies liquidity to the world markets. The point at which x% GDP deficit implies a REAL THREAT to surplus nations is unknown. What to do? The likely course of events seems to be in discussion - US Treasury Secretary Paulson has addressed the chinese to show increased currency flexibility (a large USD surplus holder) which they are now signalling. This a first step. The question remains however whether the opening of yuan currency flexibility will be fast enough to avoid the FEAR of a USD meltdown and likewise it drives US import prices higher. Obviously some nations may or are diversification into the Euro and maybe even gold (e.g. Russia plans to increase its Central Bank holdings) is underway as a precautionary step.

To conclude, curently the IMF is foreseeing that the Q4 2006 and 2007 outlook is for a continued intermediate global growth and stated :

Directors identified a number of downside risks facing the global economy going forward. These include the possibility that a continued buildup of inflationary pressures in advanced economies might require a more aggressive monetary policy response; the continued potential for supply-side shocks in the oil and nonfuel commodity markets; the risk of a more abrupt slowdown in housing markets in advanced economies, notably the United States; and the possibility of weaker-than-expected growth in inprivate consumption in Europe and Japan, due to slow productivity growth and labor market rigidities.

Based on these macroeconomic drivers, we feel the Fed will be forced to hold back on any further rates rises until sufficient direction is given in the data / markets. Bonds are falling and hence the inverted yield curve is worsening. This of course does not mean the "bond crowd" cannot be wrong, it simply means that currently the market makers see little inflationary risk on the horizon. In the short term a strengthening of the US Dollar may occur as FEAR causes a rush to the "known safety" in the USD - whether this is wise or not is a moot point - it may simply happen and the USD has been gaining strength albeit in baby steps. This allows nations to buy the necessary USD denominated resources on the world market like oil, gas, grains, basically everything. Likewise, a recessionary or bearish outlook would MOST LIKELY cause the Fed to drop interest rates in order to keep the liquidity sufficient which keeps the US consumer spending or at least NOT saving. We believe this is the environment for 2007-2008 as it looks as though the Fed has peaked on interest rate rises due to falling energy prices and reduced inflation pressures for now. This has the impact of increasing liquidity in the world markets which will likely cause higher stock markets and even higher commodity prices in a number of areas while other areas may be poor performers.

Finally, currently 2007 looks more muddle-through or benign on a number of fronts:

1. feed through from US housing weakness will likely not take hold immediately and more likely at the earliest in 2H of 2007.

2. Fed likely to hold rates through 2006 and earliest Q1 2007 talk of rate cuts.

3. Broad markets to grind higher over the next 6 months.

4. We are, at this point, more bullish on quality large caps and growth stocks as opposed to resource based stocks. That is not to say we are selling the resource positions but rather simply plan a rotation of capital since being in 50% cash will allow both buying low in resources and transition some capital into the large/growth stocks.

5. With oil moving lower the impetus to inflation is weakened and thus the Fed will be corroberated in its "holding pattern".

6. China's Yuan floating policy, although slow, will gain strength against USD and major currencies although not likely to have large impacts on trade or US consumption patterns yet.

7. More consolidation in the commodities energy & metals sectors; the bigger gains from our perspective are likely to be in 2008 based on current macro factors.

8. Commodity prices and pullbacks allow for positioning before next upleg in trend resumes - note: we remain POSITIVE mid to long term on both energy, uranium, softs and metals. Bull trends do NOT collapse in such fashion as seen over the past two months, they simply consolidate before going higher. Three billion Indian and Chinese are not disappearing nor their desire for economic improvement and to do that they require resources.