National Bank Financial says it expects stocks to outperform bonds, but it’s nevertheless paring back its equity exposure because of risks it sees gathering on the horizon.

In a new report, NBF’s chief strategist Clément Gignac says the bank it is pulling back its equity exposure to 55% from 60%; which is still greater than a market weight of 50%. The assets are instead being put into cash, boosting that part of the portfolio to 20%. “Our initial 2004 yearend targets on the S&P 500 (1225) and S&P/TSX (9200) have been postponed by six months,” he says. “We continue to regard bonds as expensive and recommend an underweight position with a 25% exposure (neutral at 40%).”

The big risks it sees to stock prices are: Middle East tensions and high oil prices; the possibility that Japan could stop trying to control the Yen, hurting U.S. treasuries and foreign exchange markets; and, higher interest rates in the U.S.

On a sector basis, it is cutting its exposure to bank stocks. “We are taking profits on bank stocks and downgrading the sector to an underweight recommendation, a first in almost five years,” it says. “Despite strong balance sheet and attractive dividend yield, capital markets revenues should become more erratic with the unwinding liquidity from central banks. Moreover, low loan losses provisions, which have contributed to profit margin expansion over the last three years, have likely bottomed out.”

On the positive side, Gignac says that the financial sector is not as rate-sensitive as it used to be. But, Canadian banks could also be whacked if the U.S. housing market cools and kills the earnings in regional banks, which are heavily dependent on mortgage securitizations.

Instead, investors should look to diversified financials. “High earnings revisions coupled with appealing valuation levels account for our positive recommendation,” it says. But it should beware of valuations in real estate stocks.

As for other groups, “We are sticking with our overweight recommendation on the resources sector (golds, energy, base metals, paper),” Gignac says. “On top of an expected further US dollar depreciation, commodities prices should benefit from the strongest worldwide economic growth since late 70`s.”