A general note on Marx's methodology first, after exhibiting the underlying structures of value, its relationship to labour, and the various forms in which value expresses itself, he takes his previous exegesis and sews it in the place of his original target of analysis; commodity production and exchange. I've put this previously as using his account of commodity fetishism in reverse; taking the mode of appearance of socioeconomic reality and analysing its structure (the account so far, including of commodity fetishism), he then pivots on this revealed structure and embeds it in the mode of appearance of socioeconomic reality.
A reasonable analogy here might be in terms of modular programming. You have a big task to do, you break it up into little components which are easier to solve, solve the components and substitute the solved components into the overall logic linking them. The overall logic linking them in my analogy is the structure of commodity production and value in capitalism (the topic of chapter 1), the components here are the duality of use and exchange, the consequences of this duality in terms of the social structure of labour, the distinction between abstract and concrete labour, the value forms and commodity fetishism (the broad subtopics the chapter deals with); all of these subtopics are 'passed' to the overall logic of the account and will be referenced as modules to be called upon later in the book, and checked for required modifications.
The subsequent account these modules and logic facilitate is that of the circulation of commodities and money; setting out the semantics for x is worth y in terms of the value forms, use and exchange, labour power and abstract labour, interface with agents in exchange networks as different facets of the process. For the workers, C-M-C', the expenditure of labour power in the production of a commodity becomes codified in the relationship between a labourer and their place of work - as a wage labourer. Providing the semantics for labour as a commodity in C. Exchange of (supposed) equivalents then forms the semantics for the transition from C-M (it is an act of exchange, being payed for your work) and from M-C (an act of exchange, using wages to buy goods and services).
The top down perspective, from exchange to labour, becomes codified in the moments M-C-M', the dashes are given a meaning through Marx's account of exchange and the value forms, and starting from M rather than C is viewing the perspective from the
acquisition of labour (ownership!) rather than its
expenditure.
So, with that note on broader context and methodology out of the way...
Marx characterises commodity fetishism from a slightly different angle next, from the perspective of the constitutive producers of commodities rather than top down from exchange. From the next paragraph we get the often quoted 'material relations between persons become social relations between things'. He also re-emphasises the necessity of the social division of labour in producing commodity fetishism, and gives a brief characterisation of how the social division of labour actually facilitates commodity fetishism.
As a general rule, articles of utility become commodities, only because they are products of the labour of private individuals or groups of individuals who carry on their work independently of each other. The sum total of the labour of all these private individuals forms the aggregate labour of society. Since the producers do not come into social contact with each other until they exchange their products, the specific social character of each producer’s labour does not show itself except in the act of exchange. In other words, the labour of the individual asserts itself as a part of the labour of society, only by means of the relations which the act of exchange establishes directly between the products, and indirectly, through them, between the producers. To the latter, therefore, the relations connecting the labour of one individual with that of the rest appear, not as direct social relations between individuals at work, but as what they really are, material relations between persons and social relations between things.
The first sentence, 'as a general rule... other' summarises the previous developments of the section, commodities are useful goods that are produced for exchange', and it is because they are produced for exchange that 'the private individuals' who work on them encounter others' labour as their resultant goods rather than the workers who are producing them. This also uses the previous established idea that production for exchange levels all commodities to the structure of their value alone without their material constitution - as Marx puts it (with my comments in brackets) 'the specific (concretely useful) social character of each producer’s labour does not show itself except in the act of exchange (as raw social labour)'.
One way of summarising the economic relationships between groups of commodity producers is that they only encounter the product of other groups' labour in terms of the finished product in the market. Commodity fetishism, then, is the peculiarity that the only social engagement producers have with other groups of producers, vis-a-vis production, is place the product has in a shop.
This is also echoed in C-M-C' as the facets of circulation that wage labourers have access to are their own labour power (the original C) and the goods and services they buy with it (C'). IE, workers are isolated from each other through the exchange abstraction, and only meet as the commodities they produced being held on a shelf.
So, despite Marx's characterisation of commodity fetishism as mysterious, and as a 'theological subtlety', it's nevertheless a real part of capitalist production. For Marx, it really is the case that workers from different factories only encounter different worker groups' labour through the market. That is, commodity fetishism is (again) not simply a psychological state of over-emphasis on commodities or arbitrary desire for useless tat, it has the specific meaning of social relationships between worker groups being mediated by exchange - through the market.
Marx then takes a step back and relates commodity fetishism to the more central feature that commodity production is capitalism is structured to create value rather than satisfy needs (exchange value vs use value):
It is only by being exchanged that the products of labour acquire, as values, one uniform social status, distinct from their varied forms of existence as objects of utility. This division of a product into a useful thing and a value becomes practically important, only when exchange has acquired such an extension that useful articles are produced for the purpose of being exchanged, and their character as values has therefore to be taken into account, beforehand, during production. From this moment the labour of the individual producer acquires socially a two-fold character. On the one hand, it must, as a definite useful kind of labour, satisfy a definite social want, and thus hold its place as part and parcel of the collective labour of all, as a branch of a social division of labour that has sprung up spontaneously. On the other hand, it can satisfy the manifold wants of the individual producer himself, only in so far as the mutual exchangeability of all kinds of useful private labour is an established social fact, and therefore the private useful labour of each producer ranks on an equality with that of all others. The equalisation of the most different kinds of labour can be the result only of an abstraction from their inequalities, or of reducing them to their common denominator, viz. expenditure of human labour power or human labour in the abstract.
Again, this makes sense as a remark which attempts to frame workers' economic relationships with each other on a produced good to produced good basis (material relations between people turn into social relations between things), only now it emphasises the role that the notion of universal equivalent (money) plays in the satisfaction of want. The genericness of C-M-C' only makes sense if indeed there is a universal equivalent M which workers can use to satisfy their wants and needs (C') and that commodities are produced which satisfy those wants and needs (social division of labour).
The two-fold social character of the labour of the individual appears to him, when reflected in his brain, only under those forms which are impressed upon that labour in every-day practice by the exchange of products. In this way, the character that his own labour possesses of being socially useful takes the form of the condition, that the product must be not only useful, but useful for others, and the social character that his particular labour has of being the equal of all other particular kinds of labour, takes the form that all the physically different articles that are the products of labour, have one common quality, viz., that of having value.
This bit links commodity fetishism to the theme of alienation, not broached yet in the book. The link here is 'In this way, the character that his own labour possesses of being socially useful... takes the form of condition...of having value', the economic role that a worker's skills play is only the value which is created through their application and the exchange value of their labour power (their wage). The only way you matter is your productivity, not the skill which makes your productivity possible, or the social roles your skills could facilitate.