"Our base case expectation is for a recovery scenario to gradually evolve as the process of normalisation gathers pace," it said in a note.
The government's revenue shortfall has only worsened with the pandemic, which RHB said will limit its capacity to pump prime.
Meanwhile, policy risks have increased as steps are taken to boost revenue, including raising the statutory debt ceiling to 65% of GDP, and proposals to reintroduce the Goods and Services Tax, windfall taxes and a capital gains tax.
"Taken together with the poorly managed proposal for banks to waive interest on loans under moratorium for B50 borrowers, policy risks have ticked up," it said.
Further, the reopening of the global economy has led to global supply chain bottlenecks, resulting in surging food and energy costs and rising inflation.
"With the US Fed behind the inflation and employment curve, a disorderly transition to a tighter liquidity environment will have negative implications (and is unfortunate timing) for Emerging Market (EM) equities that are still struggling to overcome the effects of the pandemic," said RHB.
In terms of market strategy, while the gradual domestic economic reopening is leading to a robust recovery, RHB said this has already been partly factored in.
It expects the transition to the new normal to re-focus attention on fundamental stock plays while investor expectations will need to be backed up by earnings.
It added that investors should utilise stock-picking strategies and trading to capitalise on momentum, and high-beta names will be needed to generate alpha.
"Investors should seize on opportunities to re-weight into recovery plays at lower levels including looking out for 'bombed-out' stocks.
"Prevailing risks will require tactical exposure to defensive and high-dividend yield names," it said.
RHB has an "overweight" call on key sectors including banks, healthcare, gaming, basic materials, oil and gas, transport and logistics.
It maintained its end-2021 FBM KLCI target of 1,650 points, derived from an unchanged target price-earnings of 16 times (seven-year mean) on forward earnings.