Apparently I need to 'learn to dress myself before going out', everywhere in Morrowind. Only factions who I have a high disposition towards do not inform me that I'm naked or otherwise comment on my appearance. I'm wearing armor that appears to be Oblivion in origin (leather), instead of a Morrowind specific armor/clothes. Here's my mod list:
Mod list
Oblivion.esm Morrowind_ob.esm Unofficial Oblivion Patch.esp Oblivion Citadel Door Fix.esp DLCShiveringIsles.esp Unofficial Shivering Isles Patch.esp DLCHorseArmor.esp DLCHorseArmor - Unofficial Patch.esp DLCOrrery.esp DLCOrrery - Unofficial Patch.esp DLCVileLair.esp DLCVileLair - Unofficial Patch.esp DLCMehrunesRazor.esp DLCMehrunesRazor - Unofficial Patch.esp DLCSpellTomes.esp DLCThievesDen.esp DLCThievesDen - Unofficial Patch.esp DLCThievesDen - Unofficial Patch - SSSB.esp Morrowind_ob.esp Morrowind_ob - Chargen and Transport Mod.esp Morrowind_ob - MorroblivionTreeReplacer.esp Morrowind_ob - Morroblivion Maps.esp Morrowind_ob - Conversation.esp Morrowind_ob - UCWUS.esp Voice Overs V002.esp DLCBattlehornCastle.esp DLCBattlehornCastle - Unofficial Patch.esp DLCFrostcrag.esp DLCFrostcrag - Unofficial Patch.esp Knights.esp Knights - Unofficial Patch.esp MidasSpells.esp _Ren_BeautyPack_onlyhairs.esp _Ren_BeautyPack_full.esp OblivionReloaded.esp Oblivion_Character_Overhaul.esp Bashed Patch, 0.esp
I was hoping to get a little insight on this, as it's pretty immersion breaking (and insulting, they're not nice at all about it)!
Also, no enchanted items in the game work. No constant effects or any magical effects at all when equipped.

they're not nice at all about
You haven't met Ordinators yet, I take it :D
Seriously though, this is not a bug - NPC in this game actually comment on what you wear. Equip something more expensive if you don't like what they say.