National Bank Financial has long been cautious on equities, but today it removed its underweight recommendation, as it believes that a mild U.S. recession is now almost priced into the stock market.

NBF allows that the markets can be expected to remain volatile, and it says that further softness cannot be ruled out, but, “our comfort zone has been increased significantly by recent bold moves from U.S. policymakers, suggesting that any consumer-led recession should be mild.”

“For this reason, we perceive the downside risks becoming limited since most North American equities have recently declined 12%-15% from their previous peak,” it notes.

As a result, the firm has decided to remove its’ underweight recommendation on equities, shifting to a more neutral stance. The new recommended asset mix is 55% equities, 35% fixed income and 10% cash, changed from 40% equities, 45% fixed income and 15% cash.

“For the time being, we remain comfortable with our year-end 2008 targets of 12,800 for the S&P/TSX and 1,400 for the S&P 500,” it says.

As for bonds, it suggests that recent advances by the Canadian bond market have greatly reduced the potential returns for the next few months. “Consequently, we feel comfortable in lowering our recommendation on fixed income instruments to underweight.”

“In sector rotation, we note that Canadian financials have declined 12% since the U.S. market peak in October, a pullback almost equal to their typical loss in U.S. recessions. This development, coupled with the fact that Canadian bank dividend yields are now above 10-year bond yields for the first time in at least 35 years, leads us to remove our underweight recommendation on banks,” it adds.

“Considering that interest-sensitive utilities have outperformed the market by 9% since Oct 2007, we are removing our overweight recommendation on the sector,” NBF concludes. It also continues to recommend overweighting gold stocks on the weaker US dollar, and recent Fed actions, which, it says, should provide significant support for the price of gold.