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When Will Cotton Finally Settle Down?

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Apparel giant Gap (NYSE: GPS  ) recently reported a 23% drop in its first-quarter earnings, as its cost of goods unsurprisingly shot up. Gap foresees higher input costs weighing on margins throughout 2011. Inflation is once again running rampant through many businesses, and retailers and their thin margins are some of the worst-hit.

Fortunately (or not), it's not just Gap getting hit. A number of other apparel companies are on their toes, thanks largely to higher cotton prices.

Aeropostale (NYSE: ARO  ) reported a fall in its first-quarter earnings due to cost pressures. American Apparel (AMEX: APP  ) raised retail prices to help offset increasing yarn and fabric prices.

The same story unfolded for stocks such as American Eagle Outfitters (NYSE: AEO  ) and Abercrombie & Fitch (NYSE: ANF  ) , which dropped sharply last week on concerns that higher cotton prices would eat into their bottom lines.

The Asian edge
China, the largest cotton producer in the world, faced crunches in cotton supply due to droughts. The second-biggest producer, India, experienced unseasonal rains and restricted its exports to safeguard domestic supplies. In addition, speculation that cotton prices would soar further led to hoarding, creating an artificial shortage and perhaps much speculation in the commodity futures market.

In the last month, raw cotton and cotton yarn prices seem to be cooling off from their peaks. How long will the cotton-caused cost pressures continue? That's not easy to answer, but developments bubbling up in countries like India can give us a clue where cotton prices could be headed.

The Indian government, for instance, is mulling raising export volumes soon. India had capped its cotton exports for the current year at 5.5 million bales, but owing to increasing unsold stock before the new crop season, the government is looking at lifting the ban on exports soon and clearing that inventory.

If this happens -- the chances of which appear high -- mills will be in a position to sustain margins, produce more, and so export more. With increased supply, there will be some restoration of balance in the demand-supply curves, stabilizing prices for American producers and retailers.

The Foolish bottom line
In the absence of restored cotton price norms, retailers will do their best to pass the buck to consumers, which is rarely a good thing in a stressed economy. So the sector may be looking a little shaky for now. Stay tuned.

Neha Chamaria does not own shares of any of the companies mentioned. The Motley Fool owns shares of Aeropostale. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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