Updates (Things I've tried to solve/working around this issue.)
1. Are changes in the player's velocity not being communicated properly between the peer and host?
Tried enabling physics for the peer and setup transferable velocity x and y values but this did not change anything.
2. Is it related to physics?
Completely removed physics and replaced everything with a custom movement equivalent and got the same result.
3. Is it related to precision/interpolation of transferable values?
Tried maxing out precision and experimenting with interpolation, did not produce anything of value.
4. Did I set something up wrong?
I edited the "Multiplayer Game" example provided by Scirra so that holding "W" (input: 0,1) would cause the peer to accelerate toward their lookaty, lookatx coordinates. This resulted in the same choppy movement I have been experiencing.
5. Does the peer need physics/custom movement enabled?
I tried enabling physics/custom movement for the peer's character, and allowing them to move it alongside input prediction, but it did not change anything.
Does no one know why this is happening?