What is do is very similar DexCisco does. I usually have 1 city into well into the game, although I will build multiple outposts in order to harvest shards or gold/iron deposits. Occasionally I will build a 2nd city if I happen upon a good location.
As Dex says, I often leave my cities and outposts undefended early in the game because monsters don't attack them. So outposts are just a cheap way of expanding your territory and claiming shards. Obviously, the counter to this is to have monsters raze undefended outposts.
Once you clear the area around your cities, you almost never have any monsters come near. I think this should be tied to the unrest rate, the higher the unrest, the more wandering monsters and bandits that invade your territory. This could also be tied to the number of defenders in the city. A lighly defended city would be more prone to have bandit/wandering monster issues than a well defended one. The only issue here is that this might create a 'training ground' for untested units and players might leave cities undefended or lightly defended in order to get XP to units.
Monsters rarely destroy improvements. I build on a fire shard right next to a lair of spiders and they never attacked it. That sort of thing should be automatic.
Monster armies need to have MORE and tougher creatures. Too many Strong/Medium armies are just full of 6 or 7 very low level creatures. There needs to be HORDES of creatures with tougher levels and defense.
Monsters don't have enough special traits. Especially the bosses. Bosses should be the equilent of a 20th level hero in the number of traits that they have available.
The only spells I generally use are HASTE, SLOW, GROWTH, SHRINK, BLINDNESS and HEAL. Burning hands does too little damage, flame dart generally doesn't do enough for the cost. Most of the spells that take 1 turn to cast other than Blizzard are not worth the cost either. Monsters should have a greater spell resistance and Growth/Haste/Slow need to cost more. The only strategic spells are use are Lower Mountain, Cloud Walk, Firestorm (if I can't get a army in fast enough) and sometimes Flame Blade and Regeneration on my heroes early in the game.
Unrest (and I have said this before) is not a game mechanic that I pay any attention to because the only libility seems to be is reduced production and research and usually I have built buildings that counter these penalties. High unrest should cause growth to go negative, bandits to appear nearby to destroy improvements and caravans. Lowering unrest should be a goal of the game.
I generally will try to recruit one hero, but I have played games where the only 'army' I had was my sovereign. When I train units early in the game, I train pioneers to build outposts to claim territory. I usually focus on Civics and weapons (to get leatherworking) and only in magic to get shard harvesting (which should be higher up IMO). I think magic needs more lower level items to make it attractive.
Diplomacy, rarely use it because it's Lame (sorry). You really can't trade anything to another sovereign and when they have a supposed military rating higher than you they ask for a ridiculous amount of gilder to get a non-aggression treaty. Since there seems to be plenty of grain/material/horses/metal/etc. there really isn't any reason to talk to them other than to go to war.
So while I am having a lot more fun playing FE than I ever did with WoM. Monsters (at least Strong and above) need to be tougher and smarter and cities still seem to be lacking although I think you are headed in the right direction. I'm not sure what you are ultimately planning for Diplomacy, but right now it's pretty irrevelent.
