Never mind, I took some time to patch libvirt to see if it would have
any effect. Appears to only apply to the records dnsmasq receives the
DNS queries it makes, doesn't ignore any addresses read in from
/etc/hosts.

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https://bugs.launchpad.net/bugs/1326536

Title:
  libvirt's dnsmasq setup will read /etc/hosts on the host, resulting in
  odd resolution behaviour on the VM

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