Clem? *Dies of Ickiness.* Oh Gosh.
But yes. I am fairly certain that the daughter looked funny because she was not really Xander's. Poor guy hurt his back helping Buffy, you know, and Anya has her needs... eww. I just grossed myself out with that one. I mean, by the looks of the kid's ears, the demon had to be pretty nasty.
Seriously, though, that was part of one of their fights. Anya said something like "I wasn't the one who stopped touching!" Xander came back with something like, "That may be true... but you sure as Hell weren't touching me!" It was really awful. I mean, Anya and Xander had the physical part of the relationship down even before the emotional part, so for them to get to the point at which they had absolutely no physical intimacy was just... sad. Tragic, even.
One thing I didn't understand is why Xander never questioned Fake Old!Xander about why he never left Anya. I mean, when the funny-eared illegitimate kid pops out, that seems like a pretty clear indication that it's time to leave. Why didn't Xander ask the old man why he chose to stay? Did he believe it because Xander is so loyal? Maybe that's one of the personality traits the demon was using against him -- that even in this nightmare scenario, Xander would be loyal to the (absolutely horrible) end.